Hedging Introduction

Question 1

What are the elements of hedging

Answer 1

Hedged Item + Hedged Instrument = Hedge

Question 2

What are the categories of hedging?

Answer 2

1) Natural/Economic Hedge: Use a derivative to offset the price of a commodity, interest rate, purchase of inventory, or foreign exchange currency. No special accounting.
2) Hedge Accounting- Same as above, but when certain criteria are met there is special accounting for the hedging instrument and the hedged item.

Question 3

How do you “Qualify” for Hedge Accounting?

Answer 3

1) Formal Documentation- Management has to formally document why they are hedging. Things that need to be documented include the strategy and objective for taking on the hedge. What items are being hedge.
2) Hedging Instrument (Derivative)
3) Hedged Item (Risk)

Question 4

What items are eligible for hedge accounting?

Answer 4

1) Commodity Price Risk- Risk of loss due to changes in the value of commodity
2) Foreign Exchange
3) Interest Rate Risk
4) Credit Risk

Question 5

What are the two types of hedge accounting?

Answer 5

1) Fair Value (FV) hedge- the hedged item has a fixed cash flow and variable value
2) Cash Flow Hedge- The hedge item has variable cash flows, fixed fair value