What is a cash flow hedge? (with photo)

A cash flow hedge is a type of investment strategy established to protect an individual against the variable cash flow risk of a specific hedged item.

A cash flow hedge is a type of investment strategy established to protect an individual against the variable cash flow risk of a specific hedged item. This risk can be caused by specific assets or liabilities that generate revenue differently than expected and are possibly reducing expected profits or increasing losses. For example, a cash flow hedge may protect against increases in the repayment installments of a variable rate loan, increases in the exchange rate of a foreign currency in which the individual expects to make a future transaction, or increases in the prices of planned inventory purchases. This financial strategy uses derivative instruments, such as call or put options, to help limit an individual’s exposure to such risks. Specific information, such as the original hedge strategy and risk, must be documented before a cash flow hedge can be properly established; in most cases, a financial advisor can help investors create financial protection for covered items.

Types of Risks

In general, a cash flow hedge is put in place to help protect against currency risk, price risk, or exposure to the cash flow effects of financial instruments. Foreign exchange risks include those associated with a future transaction in a foreign currency or a debt denominated in foreign currency. Price risks refer to the possibility that the purchase price of non-financial assets will increase or the selling price of non-financial assets will decrease. Floating income from financial instruments may be due to price changes, changes in the benchmark interest rate, changes in the credit spread between the hedged item’s interest rate and the benchmark interest rate, and defaults or changes in credit quality. .

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Buy versus sell options

Two common instruments used to create a cash flow hedge are call and put options. Both options are legal agreements between two parties, the buyer and the seller, and both allow a transaction to take place, without requiring it. A call option allows the investor to buy from the seller a predetermined amount of assets during a specific period of time, but the purchase is not mandatory. Put options are the opposite in that the buyer of a put option can sell assets to the seller, in which case the seller is obligated to buy them, but the buyer is not obligated to sell if they wish.

For example, a farmer suspects that wheat prices may fall in the near future, reducing the selling price of his next crop. The farmer establishes a cash flow hedge by buying puts on wheat futures, which would produce profits if wheat prices fell. In this way, the profits from the puts would offset the losses from the reduced sell price if the price of wheat did fall. If the price of wheat rises, the farmer will lose the amount of money he used to buy the options, but he will profit from the higher price of wheat.

Qualifying investments

To qualify for cash flow hedge accounting treatment, a hedge fund must meet certain criteria. At the beginning of the original hedge fund process, the individual who sets up the investment must prepare documents stating its objective and strategy, as well as the method that will be used to determine the effectiveness of the investment. Investors must also provide details about the risk and the date, or time period, when the cash flow would occur. The cash flow hedge must sufficiently offset changes in income related to the hedged item. The transaction must be probable and must be carried out with an entity other than the original hedge.

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