CFM27010 - Accounting for corporate finance: hedging: what is hedging?

What is hedging?

An economic hedge is achieved when changes in the fair value or cash flow of a hedged item are offset by equal and opposite changes in the fair value or cash flow of the hedging instrument, which is frequently a derivative.

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation that:

• Exposes the entity to the risk of changes in fair value or future cash flows and
• Is designated as being hedged.

A ‘firm commitment’ is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates. For example, a company that has signed a contract to buy or sell trading stock or some other asset at a later date, will have a firm commitment.

A ‘forecast transaction’ is an uncommitted but anticipated future transaction. For example, suppose a company has a multi-currency borrowing facility with a bank. It expects at some future date to draw down $50 million under the facility but isn’t committed doing so. The draw down would be a forecast transaction.

A ‘net investment in a foreign operation’ is the amount of the reporting entity’s interest in the net assets of an entity that is a subsidiary, associate, joint venture or branch of the reporting entity, the activities of which are based or conducted in a functional currency other than that of the reporting entity.

Hedging takes place by means of a hedging instrument. This is a designated derivative or, for a hedge of the risk of changes in foreign currency exchange rates only, a designated non-derivative financial asset or liability, whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

The degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedged instrument is termed hedge effectiveness.

For example, suppose that a company has a foreign currency borrowing, and has hedged the foreign exchange risk by entering into a forward currency contract. If, in a particular reporting period, the fair value of the liability decreases by £100,000 because of exchange movements, and the fair value of the currency contract increases by £100,000, the hedge is 100% effective. If the fair value of the currency contract increases by only £90,000, the hedge effectiveness is 90%. You can, with equal validity, look at it the other way round and say the hedge effectiveness is 111% (100/90 x 100% = 111%).