How companies use derivatives: hedge accounting
Companies hedge to steady earnings and cash flows against moves in rates, currencies and commodity prices. Hedge accounting lets them match the derivative's gains and losses with the hedged item under three labels: cash flow, fair value and net investment hedges.
Before this: Derivative risks: leverage, basis, liquidity, counterparty and systemic, Interest rate swaps: fixed vs floating
On the exam
- Compare the use of derivatives among issuers and investors
Compare issuer and investor uses of derivatives. Expect to classify a hedge as cash flow, fair value or net investment, to explain why issuers prefer customized over-the-counter (OTC) contracts, and sometimes to compute the net result of a hedge.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
Why do companies hedge?
Companies face price risks that come with running the business: input costs, foreign currency, and interest on debt. Left alone, these swings make earnings volatility larger. Volatile earnings can raise a company’s borrowing costs and make it harder for investors to estimate future profit. Companies therefore use derivatives to offset market-based exposures in their assets, liabilities and earnings. Many also adopt a risk policy that sets objectives, limits and approval steps.
What is hedge accounting?
Derivatives are carried on the balance sheet at fair value. Unless a derivative is embedded in another instrument or qualifies for hedge accounting, its value changes are marked to market through earnings. That creates a problem: a perfectly sensible hedge makes earnings jump about, because the derivative’s gain or loss is recognized now while the hedged item’s effect arrives later.
Hedge accounting fixes the timing. It allows the issuer to offset the hedging instrument (usually a derivative) against the hedged transaction or balance sheet item, so both reach earnings together. For a cash flow hedge, the derivative’s interim changes are held in other comprehensive income (OCI), an equity account, and released into earnings when the hedged item is recognized.
What are the three designations?
- Cash flow hedge Memorize absorbs variable cash flows
- Pay-fixed swap on floating-rate debt variable becomes fixed
- Foreign exchange (FX) forward on forecast foreign sales future proceeds fixed
-
- Fair value hedge Memorize offsets a change in the value of an asset or liability
- Receive-fixed swap on fixed-rate debt fixed becomes floating
- Short futures on inventory protects the inventory value
-
- Net investment hedge Memorize offsets FX risk on the equity of a foreign operation
- Currency forward or currency swap derivative hedge
- Foreign-currency bond non-derivative hedge
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A cash flow hedge absorbs the variable cash flow of a floating-rate asset or liability, or of a forecast transaction. Either forward commitments or contingent claims can serve. Typical cases: a pay-fixed swap on floating-rate debt, a foreign exchange (FX) forward on forecast export sales, a swap fixing next year’s gas purchases.
A fair value hedge offsets the fluctuation in the fair value of an asset or liability. Typical cases: a receive-fixed swap that turns fixed-rate bonds into floating-rate debt, or short futures against commodity inventory.
A net investment hedge offsets the exchange rate risk on the equity of a foreign operation, using a currency forward or swap or a foreign-currency bond.
Exam tip Ask what is being protected. A stream of future cash flows is a cash flow hedge. The value of something already on the balance sheet is a fair value hedge. Equity in a foreign subsidiary is a net investment hedge.
A company has a floating-rate loan at the reference rate plus 1.50% and enters a swap paying 4.20% fixed and receiving the reference rate. Its all-in borrowing rate is closest to:
4.20% + 1.50% = 5.70%
All-in fixed borrowing rate, R5.70%
- 4.2+1.5=5.7
- 4.2ENTER1.5+5.7
ENTER enter (on the HP, puts the number on the stack)
A producer holds 400 units of inventory worth 9,000.00 each and sells futures at 9,060.00. Later the spot price is 8,500.00 and the futures price is 8,570.00. The combined gain or loss on inventory and futures (a negative number is a loss) is closest to:
400 × [(9,060.00 − 8,570.00) − (9,000.00 − 8,500.00)] = -4,000.00
Net result of inventory plus hedge, N-4,000.00
- 9060−8570−9000+8500=×400=-4,000.00
- 9060ENTER8570−9000−8500+400×-4,000.00
ENTER enter (on the HP, puts the number on the stack)
Why do issuers mostly use OTC contracts?
To qualify for hedge accounting, the dates, notional amounts and other terms of the derivative must closely match those of the hedged item. Standardized exchange-traded contracts rarely fit. A company hedging a payment 75 days away cannot buy a 75-day futures contract, and using a two-month future leaves part of the exposure open and creates earnings volatility from the derivative. So issuers mostly use customized OTC forwards and swaps from a dealer, and accept the credit risk that brings.
Go deeper Where the gains and losses appear
In a cash flow hedge, the derivative’s value changes sit in OCI and move into earnings when the hedged cash flow is recognized, for example when the forecast sale takes place or the interest accrues. In a fair value hedge, the change in the derivative and the offsetting change in the hedged item both go through earnings in the same period. For a net investment hedge, the derivative’s gain or loss is reported alongside the currency translation of the foreign operation, also in OCI. The financial statement lessons on long-term liabilities and equity show these items.
Go deeper Documentation and effectiveness testing
Hedge accounting is not automatic. The company must document the hedge relationship and its purpose from the start and show that the hedge is expected to offset the hedged item effectively. A hedge that does not qualify is simply marked to market through earnings.
Memorize this
MemorizeHedge designations
| Designation | Offsets | Examples |
|---|---|---|
| Cash flow | variable cash flows (floating items, forecast deals) | pay-fixed swap on floating debt; FX forward on forecast sales |
| Fair value | change in value of an asset or liability | receive-fixed swap on fixed debt; short futures on inventory |
| Net investment | FX risk on foreign operation equity | currency forward or swap; foreign-currency bond |
Memory hook Cash flow hedges turn variable into fixed. Fair value hedges turn fixed into floating, which protects a value. Net investment: the word "investment" means a foreign subsidiary.
Know it cold Hedge accounting needs a close match of dates, amounts and terms, so issuers mostly use customized OTC contracts.
MemorizeWhere the gain or loss goes
Memory hook No hedge accounting: every change hits earnings now. Hedge accounting: gains and losses meet the hedged item.
Know it cold Cash flow hedge: derivative changes wait in OCI until the hedged item reaches earnings.
- Cash flow hedge Memorize absorbs variable cash flows
- Pay-fixed swap on floating-rate debt variable becomes fixed
- Foreign exchange (FX) forward on forecast foreign sales future proceeds fixed
-
- Fair value hedge Memorize offsets a change in the value of an asset or liability
- Receive-fixed swap on fixed-rate debt fixed becomes floating
- Short futures on inventory protects the inventory value
-
- Net investment hedge Memorize offsets FX risk on the equity of a foreign operation
- Currency forward or currency swap derivative hedge
- Foreign-currency bond non-derivative hedge
-
Quick example
A loan pays the reference rate plus 0.90%. A pay-fixed swap at 4.25% receives the reference rate. All-in rate = 4.25% + 0.90% = 5.15%, whatever the reference rate does.
- 4.25+0.9= 5.15
- 4.25ENTER0.9+ 5.15
ENTER enter (on the HP, puts the number on the stack)
Quick example
1,200 ounces; futures sold at 2,034 and later at 1,990; spot falls 2,020 to 1,970. N = 1,200 × [(44) − (50)] = −7,200.
- 2034−1990−2020+1970=×1200= -7200
- 2034ENTER1990−2020−1970+1200× -7200
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Swap on floating-rate debt
A firm swaps floating-rate debt to fixed. Designation?
Cash flow hedge (variable becomes fixed). Trap: fair value hedge.
-
Swap on fixed-rate bonds
A firm receives fixed and pays floating on its bonds. Designation?
Fair value hedge. Trap: cash flow hedge.
-
Foreign subsidiary
A parent hedges the equity of an overseas subsidiary with a currency forward.
Net investment hedge.
-
Why OTC
Why do issuers prefer OTC derivatives for hedging?
Custom terms match the hedged item and qualify for hedge accounting. Traps: no credit risk, lower cost.
Exam traps
- Calling a pay-fixed swap on floating debt a fair value hedge. Converting variable cash flows to fixed is a cash flow hedge.
- Calling a receive-fixed swap on fixed-rate debt a cash flow hedge. It offsets the debt's changing value, so it is a fair value hedge.
- Thinking issuers favor exchange-traded hedges. Standardized contracts rarely match the hedged item closely enough.
- Believing hedging removes all risk. A close but imperfect match leaves a small residual result.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A company with fixed-rate bonds outstanding enters a swap to receive fixed and pay floating. Under hedge accounting this is most likely a:
2A UK parent hedges the GBP value of its US subsidiary's equity with a currency forward. This is a:
3Corporate issuers prefer OTC derivatives for hedging most likely because:
4A company has a USD 25,000,000 floating-rate loan at the reference rate plus 1.20%. It enters a swap paying 3.80% fixed and receiving the reference rate. The company's annual interest cost, whatever happens to the reference rate, is closest to:
5A gold refiner holds 2,000 ounces of gold inventory and sells futures at USD 1,961 an ounce to hedge it. The spot price then falls from USD 1,950 to USD 1,900, and the refiner closes the futures at USD 1,915. The net gain or loss on the inventory and the futures together is closest to:
Key takeaways
- Issuers hedge to cut earnings and cash flow volatility from rates, currencies and commodity prices.
- Cash flow hedge: variable cash flows. Fair value hedge: a value. Net investment hedge: FX on a foreign operation.
- Hedge accounting needs a close match, so issuers mostly use customized OTC contracts.
- Without hedge accounting, derivative value changes go straight through earnings.
Quick example
A loan pays the reference rate plus 0.90%. A pay-fixed swap at 4.25% receives the reference rate. All-in rate = 4.25% + 0.90% = 5.15%, whatever the reference rate does.
- 4.25+0.9= 5.15
- 4.25ENTER0.9+ 5.15
ENTER enter (on the HP, puts the number on the stack)
Quick example
1,200 ounces; futures sold at 2,034 and later at 1,990; spot falls 2,020 to 1,970. N = 1,200 × [(44) − (50)] = −7,200.
- 2034−1990−2020+1970=×1200= -7200
- 2034ENTER1990−2020−1970+1200× -7200
ENTER enter (on the HP, puts the number on the stack)
All Derivatives formulas, every lesson
Practice exam-style questions on Derivative Benefits, Risks and Uses
Questions about this lesson?
Where this comes back
- How investors use derivatives, compared with issuers Derivative Benefits, Risks and Uses
- Topics in Long-Term Liabilities and Equity Financial Statement Analysis
Questions candidates ask
What is the difference between a cash flow hedge and a fair value hedge?
A cash flow hedge offsets variable cash flows, such as a floating-rate loan or a forecast foreign sale. A fair value hedge offsets changes in the value of an asset or liability, such as fixed-rate debt or inventory.
What is a net investment hedge?
A derivative or foreign-currency bond used to offset the exchange rate risk on the equity of a foreign operation, for example a currency forward hedging a parent's investment in an overseas subsidiary.
Why do companies use hedge accounting?
Derivatives are carried at fair value, so without hedge accounting their value changes hit earnings at once. Hedge accounting lets the gain or loss be recognized at the same time as the hedged item, which reduces reported earnings volatility.
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