The Advantages of Hedge Accounting

Hedge accounting refers to the hedging process, which reduces or controls the risk associated with certain financial risks. Typically, this is done by taking a position in a future market that is completely opposite to the current one in an effort to reduce or limit the amount of risk associated with price changes.

This is generally a two step process. Any gain or loss in a company’s cash flow position due to price changes will be directly offset by the value of an option on a future position. For example, suppose a farmer decides to sell his corn futures before the harvest to protect the value of the corn. If the price of corn falls, this loss in the current cash market will be offset by the futures market, resulting in a gain.

Coverage Types

There are two types of hedge that you need to consider when it comes to hedge accounting.

• Long Hedge – A long hedge, also known as a buy hedge, indicates that you are buying 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 overdraft sales. Most often, long hedges are used by companies that have promised to deliver a product or service to a third party at a specific date in the future for an agreed amount, but currently do not have the supplies necessary to meet that amount. commitment. commitment immediately.

• Short Hedging – Also known as a short hedging, occurs when one party decides to sell a futures contract to reduce the amount of financial risk they have, the cost of the product, to protect inventory that is not involved in a forward sale and to cover the cost of producing new products.

Coverage Benefits

So what are the benefits of hedge accounting?

When you buy options, change interest rates or currencies, or do almost anything in the market, there is always a risk due to volatility or changes that can affect the price of options. Because hedging deals with future contracts rather than current ones, it can reduce the amount of risk associated with investments because the future market will react in the opposite way to how the current market reacts. Of course, there is still a slight risk that current market rates will rise, 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 end there.

• Protection against price movements.

• Gain the ability to offer long-term sales at a fixed price

• Improve forecasts for your profits and costs

• Trade your current inventory for cash

• Manage forward sales so you can get cash now and deliver inventory at a later date

If you are considering financial risk management, there is no better option than hedge accounting. Be sure to take advantage of its many benefits today!