Fair value hedge

From CEOpedia | Management online

Fair value hedge - is "a hedge of the changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk" (O. Ray Whittington 2015, p. 197).

Hedge accounting applies to both recognized assets and liabilities, but also unrecognized liabilities. An unrecognized permanent liability is a contractual obligation that has not yet been recognized in the balance sheet, but will become an asset or liability in the future when it appears in the balance sheet. A firm commitment must relate to a specific quantity, price and date and must be legally binding on each party (customer and supplier). To apply hedge accounting to cover fair value risk, the hedging position must be a single asset or a group of assets, liabilities or liabilities whose values change together (D. Sahilian, M. Botea, D.L. Trasca 2013, p. 100).

"All changes that occur in the process of hedging will be reported in current earnings, the carrying value of the derivative is adjusted to fair value on the balance sheet, and the change in that carrying value from period to period is included on the income statement. At the same time, the balance sheet carrying value of the hedged item is also adjusted so that unrealized gains and losses due to the hedged risk offset the gains and losses on the derivative" (D. Sahilian, M. Botea, D.L. Trasca 2013, p. 100).

Discontinuance of a fair value hedge

"The accounting for a fair value hedge should not continue if any of the events below occur (B.J. Epstein, R. Nach, S.M. Bragg 2009, p. 306):

  1. The criteria are no longer met;
  2. The derivative instruments expire or are sold, terminated or exercised; or
  3. The designation is removed".

If the fair value hedge is waived, a new hedging relationship can be created with another hedging instrument and / or another item that has been decided to hedge, provided the criteria in ASC 815 are met (B.J. Epstein, R. Nach, S.M. Bragg 2009, p. 306).

Ineffectiveness of a fair value hedge

Unless the abbreviation method is applicable, the notifying entity must assess the effectiveness of the hedge at the start of the hedge and then at least every three months. In addition, ASC 815 requires that at the beginning of the collateral the method to be used to assess the effectiveness of the collateral. "To comply, the reporting entity should decide which changes in the derivative's fair value will be considered in assessing the effectiveness of the hedge, and the method to be used to assess hedge effectiveness". Some derivatives (options) have two components: intrinsic value and time value. The internal value is the possible surplus of the market price over the strike price. Internal value means that the price of a given item may be higher than the strike price (in the case of a call) or less than the strike price (in the case of a sale) during the implementation period. The enterprise decides to measure efficiency by including or excluding time value; it must do it consistently after the determination. That is why, if a company does not take into account its consequences in the long run when making a decision, securing the value of a given item may prove ineffective (B.J. Epstein, R. Nach, S.M. Bragg 2009, p. 306).

Examples of Fair value hedge

  • Hedging against changes in the fair value of inventories: A company may enter into a hedge to protect against a decrease in the fair value of its inventories due to changes in market prices. For example, a company may enter into a futures contract to purchase a certain commodity at a predetermined price to protect against a decrease in the fair value of its inventories.
  • Hedging against changes in the fair value of an unrecognized firm commitment: A company may enter into a hedge to protect against a decrease in the fair value of an unrecognized firm commitment due to changes in market prices. For example, a company may enter into a forward contract to purchase a certain commodity at a predetermined price to protect against a decrease in the fair value of its unrecognized firm commitment.
  • Hedging against changes in the fair value of a foreign currency: A company may enter into a hedge to protect against a decrease in the fair value of its foreign currency due to changes in exchange rates. For example, a company may enter into a currency swap or a foreign currency option to protect against a decrease in the fair value of its foreign currency.

Advantages of Fair value hedge

A fair value hedge is a hedge of the changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk. Some of the advantages of this type of hedge include:

  • Reduction of volatility: Fair value hedges reduce the volatility of the asset or liability as it is hedged against the risk of a change in fair value.
  • Lower cost: Fair value hedges are generally less expensive than other hedging strategies, as they are designed to hedge against a specific risk.
  • Improved accuracy: Fair value hedges can provide more accurate risk management, as they are tailored to the specific risk being hedged.
  • Transparency: The hedging process is transparent, as the hedging instrument and the risk being hedged are clearly identified.

Limitations of Fair value hedge

Fair value hedge is a useful tool to protect against changes in the fair value of assets or liabilities, but it has several limitations. The limitations of fair value hedge include:

  • Inaccurate measurement of the hedge ratio: Fair value hedging relies heavily on the accuracy of the hedge ratio, which is the ratio of the hedging instrument to the item being hedged. If the hedge ratio is inaccurate, then the hedge may be less effective than expected.
  • Market risk: Fair value hedging is subject to market risk, meaning that the fair value of the hedging instrument can be affected by changes in the overall market.
  • Complexity: Fair value hedging is a complex financial instrument, and requires extensive knowledge of the markets and the instruments being used.
  • Counterparty risk: Fair value hedging requires the use of a counterparty, which increases the risk of default. This can result in losses if the counterparty is unable to fulfill its obligations.

Other approaches related to Fair value hedge

An introduction to the other approaches related to Fair value hedge is that these include the use of derivatives and hedging instruments, as well as other forms of financial engineering. These approaches can help reduce exposure to market risk and help manage the potential for losses on investments:

  • Derivatives: These are investment instruments that derive their value from another asset or security. Derivatives can be used to hedge against market risks, including changing interest rates, exchange rates, and commodity prices.
  • Hedging instruments: These can be used to reduce exposure to market risk, such as interest rate risk, currency risk, and commodity price risk. Examples of hedging instruments include forward contracts, options, futures, and swaps.
  • Financial engineering: This involves the use of financial instruments and strategies to manage risk, such as the use of leverage, structured products, and derivatives.

In summary, Fair value hedge is a hedge of the changes in the fair value of a recognized asset or liability, and there are several other approaches related to Fair value hedge, such as the use of derivatives and hedging instruments, as well as other forms of financial engineering. These approaches can help reduce exposure to market risk and help manage the potential for losses on investments.


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References

Author: Patrycja Czerwiec

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