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What is a Cash Flow Hedge?

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  • Originally Written By: Deanira Bong
  • Revised By: Bott
  • Edited By: Jenn Walker
  • Last Modified Date: 03 December 2016
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A cash flow hedge is a type of investment strategy set up to protect an individual against the risk of variable cash flow of a specific hedged item. Such a risk may be caused by particular assets or liabilities that generate revenue differently than expected, and are possibly reducing expected profits or increasing losses. For example, a cash flow hedge could 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 options or put options to help limit the individual's exposure to such risks. Specific information, such as the strategy and risk of the original hedge, 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 hedged items.

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Types of Risks

In general, a cash flow hedge is put in place in to help protect against currency risks, price risks, or exposure to cash flow effects of financial instruments. Currency risks include those associated with a future transaction in a foreign currency or a debt denominated in a foreign currency. Price risks refer to the possibility of the purchase price of non-financial goods increasing or the sale price of non-financial goods decreasing. Fluctuating revenue of financial instruments could be due to price changes, benchmark interest rate changes, changes in the credit spread between the interest rate of the hedged item and the benchmark interest rate, and defaults or changes in creditworthiness.

Call Versus Put 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 for a transaction to occur, without requiring it. A call option allows the investor to buy a predetermined amount of assets during a specific time period from the seller, but a purchase is not mandatory. Put options are the opposite in that the buyer of a put option may sell assets to the seller, in which case the seller is required to purchase them, but the buyer is not required to sell if he so chooses.

For example, a farmer suspects that wheat prices might drop in the near future, reducing the sales price of his next harvest. The farmer sets up a cash flow hedge by buying put options on wheat futures, which would produce profits if wheat prices drop. This way, the profits from the put options would offset the losses from the reduced sales price if the price of wheat indeed drops. If the price of wheat increases, the farmer would lose the amount of money he used to buy the options, but he would profit from the higher wheat price.

Qualifying Investments

To qualify for cash flow hedge accounting treatment, a hedge fund must meet certain criteria. At the start of the original hedge fund process, the individual who sets up the investment must prepare documents stating both their objective and strategy, as well as the method that will be used to determine the effectiveness of the investment. Investors must also provide details regarding the risk and the date, or period of time, in which the cash flow would occur. The cash flow hedge has to sufficiently offset the revenue changes related to the hedged item. The transaction needs to be probable and is required to be conducted with another entity besides that of the original hedge.

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Discuss this Article

NathanG
Post 4

@SkyWhisperer - I don’t think cash flow hedging is about currency trading, or any kind of trading or hedging in general. It’s about protecting your investments in case certain market forces, like changes in interest rates, affect the cash flow of your assets in some way or another. In these circumstances options or futures would be one way to protect your cash flow.

I don’t think investing in gold or buying currencies would help.

If you exported a product and currency fluctuations meant you made less from the product than you did before, how would buying currencies help you?

You’re not trying to trade the currencies; you want to make sure the currency conversions for the sale of your product don’t hurt you.

SkyWhisperer
Post 3

@miriam98 - I’ve been told that currency trading is very risky for inexperienced traders. A lot of people are getting into Forex trading but I’m keeping my distance for now.

Your statement about theory is correct. It’s not as easy as it sounds, and the fluctuations in the currency markets are even more volatile than stocks, in my opinion.

miriam98
Post 2

@Charred - I lived in Asia for some time. It was a period where the Japanese Yen was growing stronger against the dollar. I remember thinking to myself at the time that I should get into currency trading and bet against the dollar for awhile.

The thought of betting against my own country’s currency made me feel a little dirty, but before I could jump in, the winds of the currency markets began to change again.

Soon the dollar became stronger against the Yen, and the Euro, which once threatened to usurp the dollar as the world’s reserve currency, began to head downward.

The only way to practice any cash flow hedging in these examples would be to buy a basket of currencies that play against each other, so that in theory when one goes down, the other rises. That’s the theory anyway.

Charred
Post 1

I think that cash flow hedge investing is simply a restatement of the age old adage about investing: don’t put all your investments in one basket. Even if you don’t explicitly invest in certain hedge instruments like futures or options, you can still diversify in a way that accomplishes the same effects.

For example, one cash flow hedge example that the common investor will use is to buy gold. When stocks take a dive for inflation concerns, gold rises. So gold is a hedge against inflation. When interest rates dive, stocks tend to rally.

It’s a matter of understanding that you’ve got to play all the angles as an investor in order to preserve your capital and still make decent returns.

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