There are three recognised types of hedges: cash flow hedge, fair value hedge, and net investment hedge. Focusing on the first two hedging arrangements, our comprehensive guide to cash flow hedge vs. fair value hedge provides you with all the information you need about the benefits and limitations of these useful financial instruments.
What is a hedge?
First question, what is a hedge? Put simply, a hedge is a financial instrument that you can use to mitigate risk. Think of it like buying car insurance. Every time you head out on the road, there’s a chance – albeit, a small one – that you could get into an accident and damage someone’s property. To stop that from happening, you purchase a car insurance policy. That’s essentially what a hedge can do for you.
There are various hedging techniques that businesses and investors use to offset the risk associated with their assets or investments. Some of the most common are derivatives – contracts whose value goes in the opposite direction to the hedged item – which can help you offset the risk of your investments. Now, let’s look at two of the most common hedge forms: fair value hedge and cash flow hedge.
What is a fair value hedge?
Fair value hedges can be used to mitigate the risk of changes in the fair market value of liabilities, assets, or other firm commitments. Generally, fair value hedges move in the opposite direction of the hedged item so that they can be used to cancel out your losses. As a result, derivatives like options and futures are great examples of fair value hedges.
Fair value hedge example
Let’s see a fair value hedge example to understand this concept in a little more detail. Imagine that Company A has an asset with a value of £10,000, though management are concerned that the asset’s fair value may go down to £8,000. In order to offset this, Company A would enter into an offsetting position through a derivative contract which has a value of £10,000.
Because Company A is in an offsetting position, the fair value of the derivative contract will move in the opposite direction of the hedged item. This ensures that Company A is covered against potential changes to the fair market value of their assets and liabilities.
What is a cash flow hedge?
Cash flow hedges can help to mitigate the risks that are associated with sudden changes in cash flows of assets or liabilities, rather than the asset or liability itself. There are many different factors that can bring about these sorts of changes, such as increases/decreases in foreign exchange rates, changes in interest rates, changes in asset prices, and so on.
Cash flow hedge example
It may be worth looking at an in-depth cash flow hedge example to see how this works in a practice. Imagine that Company B needs to purchase 100 tonnes of steel, which sells for around £2,000 per tonne. So, Company B would expect to spend around £200,000 for steel. However, if the price of steel spikes to £3,000 per tonne, Company B would be left with around £100,000 in expenses that they weren’t anticipating.
A cash flow hedge could be the answer. For example, the company could enter into a forward contract with another party to purchase the steel. Then, even if the price of steel rises, your net payment will remain the same, making the forward contract the hedging instrument.
What’s the difference between cash flow hedge and fair value hedge?
As you can see, the key difference between a cash flow hedge and a fair value hedge is the hedged item. With a cash flow hedge, you’re hedging the changes in cash inflow and outflow from assets and liabilities, whereas fair value hedges help to mitigate your exposure to changes in the value of assets or liabilities. So, while fair value hedges are best suited to fixed rate items, the benefits of cash flow hedges make them ideal for variable rate items.
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