Cash Flow Hedge vs. Fair Value Hedge

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  • 0:03 What Is a Hedge?
  • 0:45 Fair Value Hedges
  • 1:37 Cash Flow Hedges
  • 2:30 Accounting for Hedges
  • 4:00 More Complex Hedges
  • 4:24 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Two main types of hedges are the fair value hedge and the cash flow hedge. Let's look at examples for both and how they are accounted for, then summarize the differences between the two.

What Is a Hedge?

What is a hedge? Let's relate this to something all of us probably have because it's required by law in most states. If you own a vehicle, one of your concerns is that it might be stolen. In order to help you sleep at night, you own an automobile insurance policy that will pay the book value of your vehicle if someone steals it. That is exactly how a good hedge works! A hedge is a financial instrument that mitigates risk. In the business world there are all kinds of risks, and a universe of hedges to help business managers sleep at night instead of worrying about them.

There are three categories of hedges allowed under accounting rules, but today we'll just be talking about the two main ones: fair value hedges and cash flow hedges.

Fair Value Hedges

Fair value hedges mitigate the risk of changes in the fair (market) value of an asset, a liability of an unrecognized firm commitment. A good fair value hedge moves in the opposite direction of the asset being hedged. When the price of a stock, for example, or a warehouse full of toys goes down, the fair value hedge goes up and cancels out the losses for whoever did the hedge.

Say your old grade school teacher Mrs. Smithson owns a hundred shares of Toys for Everyone stock. Now, she can't buy an insurance policy to protect her when the price of the stock goes down, but she can buy a put option, which is a fair value hedge. A put option allows her to sell stock at a prearranged price. When the price of Toys for Everyone was $50, she bought put options, allowing her to sell at $49. When the price fell to $43, she exercised them and canceled out most of her losses!

Cash Flow Hedges

A second category of hedges is the cash flow hedge. These hedges manage the risk associated with cash flows rather than asset or liability values. Trey is the financial manager for Flyaway Airlines. A big cost item for any airline is the cost of jet fuel. Management always worries about what will happen to their bottom line if the price of jet fuel jumps up, and they can count on Trey to help protect them.

Flyaway buys about 10,000 gallons of jet fuel per month at a cost of $5.00 a gallon. That is a cash outflow of $50,000 per month. Trey buys futures contracts, which are a cash flow hedge. That allows him, for a price of course, to buy jet fuel in that quantity at that price at some date in the future. If the price jumps to $6.00 a gallon, the airlines cash outflow would be $60,000, but the futures contract will be worth the $10,000 difference, cancelling the loss.

Accounting for Hedges

There's another major difference between these two types of hedges, and that's the accounting. In a fair value hedge like Mrs. Smithson's put options, the value of the hedge and the value of the underlying asset, which is the asset being protected, must both be included in the current period's income statement. So when the price of the toy stock falls, the value of the investment asset is reduced on the books, but at the same time the value of the put asset is increased, and they cancel each other out.

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