Cash Flow Hedge Vs Fair Value Hedge

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Cash flow hedge Vs fair value hedge

Cash flow hedge Vs fair value hedge

What is a cash flow hedge and how is it different from a fair value hedge?

A cash flow hedge is a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a component thereof. It covers future interest payments on a variable-rate debt. It also covers a highly probable forecast transaction. The requirement is that such cash flows should affect the profit and loss account.

However, a fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment or a component of any such item that is attributable to a particular risk and could affect profit or loss. In a cash flow hedge, the gain or loss on the hedging instrument and the hedged item is determined so as to find out the effective and ineffective portions of the gain or loss that arises on the hedging instrument. While the ineffective portion is written off to the profit and loss account, the effective portion is temporarily recognised in cash flow hedge reserve account which is a component of other comprehensive income. When the expected future cash flows affect the profit and loss account or when a hedge forecasted transaction occurs affecting the profit and loss account, the amount recognised earlier in cash flow hedge reserve is recycled to the profit and loss account to that extent. However, in the case of a fair value hedge accounting, the fair value changes of both the hedged item and the hedging instrument are recognised in the profit and loss account. In other words, both the effective and ineffective portions are recognised in the profit and loss account in the case of a fair value hedge.

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