Cash Flow Hedge: Example & Effectiveness

Instructor: Ryan Morales
In this lesson, you will learn about the basic concepts of a cash flow hedge. What is it? What purpose does it serve? How is it used in business? What are common examples of hedge transactions?

Suppose you are part of top management in a textile company. Your company purchases tons of cotton quarterly as raw materials for the manufacture of your textile products. You also know the price of cotton in the US market varies depending on factors such as demand/supply, climactic factors, substitutes and exchange rates. There are times cotton prices decline. There are also times cotton prices increase sharply. Now, as member of top management, how do you think your team can minimize the risk associated with fluctuating cotton prices? Any change in cotton prices could have a major impact on total production costs and ultimately, on your bottom line.

Hedging is the Answer

In situations like this, hedging may be the answer. A cash flow hedge is an investment method used to deflect sudden changes in cash inflow or cash outflow related to an asset, liability or a forecasted transaction. These changes may be brought about by factors such as changes in asset prices, in interest rates, even in foreign exchange rates. A forecasted transaction is a transaction with another party, expected to take place in the future. Every manufacturing or service firm regularly purchases commodities such as cotton, wheat, meat, sugar, oil, rubber, metal, steel, etc. for their manufacturing or service process.

We do not know what will happen to the price of cotton several months from now. It could go up or down. Hence, the eventual cash payment varies depending on the market price of cotton on purchase date. Creating a cash flow hedge could minimize that risk by converting your variable future payment into a fixed future payment. In the illustration earlier, the forecasted transaction is the planned purchase of cotton several months from today. This exposes the entity to cash flow variability. This is the hedged item.

How to do it?

To hedge, your company enters into a forward contract with another party to purchase 1,000,000 pounds of cotton in three months. Let's say the price of cotton today is $0.80 per pound. That price of $0.80 per pound becomes the contract price or agreed price. With the forward contract, you are able to lock in the price of cotton at $0.80 per pound or $800,000 regardless of the market price of cotton on your date of purchase. If, in three months, the market price of cotton rises to $1.00 per pound, your net cash payment will still be $800,000. Of course, you will have to pay your supplier $1,000,000, but you will receive the $200,000 difference from the other party of the forward contract. On the other hand, if the price of cotton drops to $0.60 on settlement date, your net cash payment will still be $800,000. That is, you will have to pay your supplier $600,000 and will have to pay the amount of $200,000 difference to the other party of the forward contract. The forward contract is the hedging instrument.

When is a cash flow hedge effective?

A hedge is considered effective if the changes in the cash flow of the hedged item and the hedging instrument offset each other. Conversely, if the cash flow of the two items do not offset each other, the hedge is considered ineffective. In our illustration, the change in the cash flow of the planned purchase of cotton (the hedged item) is totally offset by the cash flow of the forward contract (the hedging instrument), therefore the hedging is 100% effective.

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