Hedge accounting refers to the process of hedging, which reduces or controls risk associated with certain financial risks. This is typically done by taking a position in a future market that is the complete opposite of the current one in an effort to reduce or limit the amount risk associated with the changes in price.
This is generally a two-step process. Any gain or loss to a company’s cash flow position because of changes in price will be directly countered by the value of an option in a future position. For instance, let’s say a farmer decides to sell his corn futures before the harvest to protect their value. If the price of corn falls, this loss in the current cash market will be countered by the futures market and will result in a gain.
Types of Hedging
There are two types of hedging you should be aware of when dealing with hedge accounting.
- Long Hedge- A long hedge, also known as a buying hedge, indicates you are purchasing a futures contract in an effort to reduce the risk of your current cash position. This can be very beneficial, as it could allow you to replace your inventory at a lower cost and protect uncovered forward sales. Most of the time, long hedges are used by companies who have made a commitment to deliver a product or service to another party at a specific date in the future for an agreed up on amount, but do not currently have the necessary supplies to fulfil that commitment immediately.
- Short Hedge- Also known as a selling hedge, this occurs when one party decides to sell a futures contract in order to reduce the amount of financial risk they have.A few benefits of this type of hedge accounting strategy is the ability to cover the finished product’s cost, to protect inventory that is not involved in a forward sale, and to cover the cost of producing new products.
Benefits of Hedging
So, what are the benefits of hedge accounting?
When you purchase options, exchange interest rates or foreign exchange, or do almost anything on the market, there is always risk because of volatility, or changes that may affect option pricing. Because hedging deals with future contracts instead of current ones, you can reduce the amount of risk associated with investments because the future market will react oppositely of how the current market reacts. Of course, there is still a slight risk of the current market’s rates rising, but this implied volatility can be calculated using an option calculator and can be planned for. This is one of the most important benefits of hedge accounting, but the advantages don’t stop there.
- Protection against price movements
- Obtain the ability to offer long-term sales at a fixed price
- Improve forecasts relating to your profits and costs
- Exchange your current inventory for cash
- Manage forward sales so you can get cash now and deliver inventory at a later date.