Lesson 5 of 6 · 13 min
How issuers use derivatives: hedging and hedge accounting
Corporate issuers mainly use derivatives to hedge price risk that comes with their business and financing, and they seek hedge accounting so that derivative gains and losses hit earnings at the same time as the item hedged.
In short
- Commodity, currency and rate moves create volatility in an issuer's assets, liabilities and earnings, which can raise its borrowing cost and make earnings hard to forecast.
- Derivatives are reported on the balance sheet at fair value; many issuers also have policies on objectives, limits and approvals.
- Without hedge accounting, derivative MTM changes go through earnings. Hedge accounting offsets the hedge against the hedged item to reduce volatility, holding MTM in OCI until the hedged item hits earnings.
- Cash flow hedge: absorbs variable cash flows (pay-fixed swap on floating debt, FX forward on forecast sales). Fair value hedge: offsets changes in fair value (receive-fixed swap on fixed debt, selling inventory forward). Net investment hedge: offsets FX risk on the equity of a foreign operation.
- To qualify, terms must closely match the hedged item, so issuers favour customised OTC contracts.
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