What is a Cash Flow Hedge?
Cash flow hedge is a method of investment method which is used to control and mitigate the sudden changes that can occur in cash inflow or outflow with respect to the asset, liability or the forecasted transactions and such sudden changes can arise due to many factors like interest rate change, asset price changes, or foreign exchange rates fluctuations.
The forecasted transaction is the transaction with another party which is expected to happen on some future date. It is also possible to hedge risks associated with only the portion if effectiveness can be measured of the related hedge that can be measured.
Example of the Cash Flow Hedge with Analysis
There is a company X ltd having a textile business and requires tons of cotton as its raw material every quarter for the production of its textile finished products and sell in the market. It purchases the raw material from the US market and pays the dollar in exchange for the product purchased.
The prices in the market of the US depend on various factors like environmental factors, demand, and supply of the product, exchange rate variations, etc. Due to these factors, the prices of the different commodities including the cotton increase or decreases and sometimes this increase or decrease is very sharp.
Now as cotton is required by the company every quarter so the management of the company wants to minimize the risk of fluctuation of the prices of raw material, so wants to know that how they can do the same?
Analysis of this example of Cash Flow Hedge
In the present case company X ltd. requires tons of cotton as its raw material every quarter for the production of its textile finished products but the prices of cotton in the market of US depends on the various factors like environmental factors, demand, and supply of the product, exchange rates variations, etc due to which it increases and decreases frequently.
So the company doesn’t know that after several months what will happen to the cotton prices and the payment would depend on the cotton market price in the US on the date of the purchase of cotton. Any Fluctuation in the prices of cotton could have a major impact on the company’s total production costs and finally on the bottom line.
For the purpose of minimizing this risk, the company can create a cash flow hedge it can convert its future payment which is variable into the fixed future payment. As the company planned to purchase the cotton after several months this exposes to the cash flow variability and is thus the hedged item.
In order to create a hedge, the company can go for forward contract with some other party. Suppose it is decided that the company will purchase 100,000 pounds of the cotton after three months period when the price of cotton is $ 0.85 on present date, so the $ 0.85 becomes the agreed price or the contract price and the company has locked the total price as $ 85,000 regardless of cotton market price on purchase date.
Now after the three months, one out of the three situations could arise i.e., the price will increase, the price will decrease or price will remain neutral which are analyzed as below:
- Price increases: The prices after 3 months increase to $ 1.2 per pound but net cash payment of the company will still be $ 85,000 as Company has to pay $ 120,000 to Supplier, but it will receive $ 35,000 ($ 120,000 – $85,000) out of forwarding contract.
- Price decreases: The prices after 3 months decreases to $ 0.60 per pound but net cash payment of the company will still be $ 85,000 as Company has to pay $ 60,000 to Supplier, but along with this it will have to pay $ 25,000 ($ 85,000 – $60,000) to the party with whom forward contract is done.
- Price remains: The prices after 3 months remain $ 8.5 per pound, so net cash payment of the company, in that case, will be $ 85,000 which is to be paid to Supplier and there will be no loss or gain from forwarding contract.
Here, a forward contract is hedging instrument and the hedging is effective only if changes in cash flow of hedged instrument and hedging offset each other. On the other side if changes in cash flow of hedged instrument and hedging do not offset each then hedge will be considered as ineffective.
In the present case change in cash flow of cotton purchase (hedged item) is offset totally by forwarding contract cash flow (hedging instrument), making hedging 100% effective.
Advantages of the Cash flow hedge
There are several different advantages. Some of the advantages are as follows:
- It helps the company in minimizing the risk associated with the hedged item
- The hedge accounting aligns accounting treatment of hedged item i.e., cash flow and hedging instrument.
Disadvantages of the Cash flow hedge
Apart from the advantages, it has limitations and drawbacks as well which are as follows:
- A main issue with the cash flow hedge is the time when the gains or losses is to be recognized in earnings in case hedging transaction is related to the forecasted transaction.
- If changes in cash flow of hedged instrument and hedging do not offset each then hedge will be considered as ineffective and the purpose of hedging becomes unuseful.
Important points of the Cash flow hedge
- The accounting of the Cash flow hedge should be terminated in case any of the following situations arises:
- Hedging arrangement done is not effective ant more.
- Hedging instrument is expired or terminated.
- Hedging designation being revoked by the organization.
- The hedging is effective only if changes in the cash flow of the hedged instrument and hedging offset each other. On the other side if changes in cash flow of hedged instrument and hedging do not offset each then hedge will be considered as ineffective.
Cash flow hedge is a hedge of the exposure to the variability in cash flow of specific liability or asset or forecasted transaction which is attributable to a particular risk; in simple words, it is a method of investment method which is used to deflect the sudden changes that can occur in cash inflow or outflow.
All the manufacturing company or some of the service firms as well buy commodities like sugar, cotton, meat, oil, wheat, etc on a regular basis for their working, so, in that case cash flow hedge is important in order to deflect the sudden changes that can occur in cash inflow or outflow of these commodities.
This has been a guide to what is the cash flow hedge and its definition. Here we discuss the example of cash flow hedge with analysis and also its advantages and disadvantages. You can learn more about financing from the following articles –