What are the common types of cash flow hedges and how do they work?

Cash flow hedges include forward contracts, interest rate swaps, commodity hedges, options contracts, and cross-currency swaps. They work by minimizing risks associated with currency fluctuations, interest rates, commodity prices, and more, providing stability to future cash flows.

Forward Rate Agreements (FRAs): Purpose: Used to hedge against fluctuations in future interest rates. How it works: A forward rate agreement is a contract where two parties agree on an interest rate to be applied to a principal amount for a future period. It locks in the interest rate, thereby protecting against adverse rate movements.

Forward contracts has advantages like - Contracts can be tailored to the needs of the business, the terms like the size of the contract, duration can be mutually decided between the parties - There is no daily mark to market so it doesn't needs cash inflow or outflow management for the margin. Disadvantages: - As there is no Mark to market on daily basis - it can create credit risk, where parties on the losing side may default. - As it is a OTC product hence the due to limited participants the contract may not be priced well considering all the external factors. - It is complex to exit the contract before the actual expiry as it would be difficult to find a party who is interested to unroll it for you.

Future contracts are quite standard in the terms of the instrument, it has advantages like: - No credit risk as the other party is the exchange for the opposite side - Daily mark to market reduces the acrrual risks. - As the product is exchange traded hence it has good liquidity & efficient pricing. - It is quick & easy to exit the contract before the expiry as the opposite trade can be booked on the exchange itself. - Interest rates can cause considerable basis risk in the pricing of the Future contracts.

Options offer the greatest diversity of risk-reward profiles for businesses looking to offset their most complex risks. Unlike forward contracts, options give the buyer the right – not the obligation – to exchange one currency against another at a certain rate. For the privilege of participating in such favourable currency moves – without risking the possibility of an adverse fluctuation, the option buyer must pay a premium upfront. This premium represents the present value of the expected (average) payout of the option. Premium payouts would be additional costs associated with cash flow hedging activities of the business, which may turn our costlier than compared to forwards or futures based strategies.

Interest Rate Swaps: Purpose: Used to manage interest rate risk associated with variable-rate debt or investments. How it works: In an interest rate swap, two parties exchange interest rate payments. For example, a company with a variable-rate loan might enter into a swap to exchange its variable interest payments for fixed payments to hedge against potential interest rate increases.

Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. Key benefits: 1. As there is no exchange of the Notional amounts, the business has not financial transaction. 2. Swaps give the borrower flexibility - Separating the borrower’s funding source from the interest rate risk. 3. Separating the funding of a loan from the management of interest rate risk through derivatives provides flexibility, making the business more competitive.

Commodity Hedges: Purpose: Used to manage price risk associated with buying or selling commodities. How it works: Businesses involved in buying or selling commodities (e.g., oil, agricultural products) can use commodity futures or options contracts to lock in prices for future purchases or sales. This hedges against adverse price movements affecting cash flow.

1. Hedge accounting is not very complex to achieve - one needs to start small, put in place the hedge documentation outlining the strategy and assessment details. 2. It’s important for treasury management and accounting teams to communicate early and often on the hedging program. 3. While treasury may determine a strategy that is beneficial from an economic standpoint ex: Over hedging, but the accounting team may still need to put the proper documentation in place and gain auditor sign-off to support it. 4. When evaluating hedging strategies & whether to apply hedge accounting, there isn’t a one-size-fits all approach. Company size, type, structure & industry all influence whether hedge accounting is appropriate for your organization.