How a cash flow hedge can help you to secure your company's future

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A cash flow hedge protects the cash flow against fluctuations.

A cash flow hedge is a financial instrument that allows companies to hedge their future cash flows against fluctuations, e.g. when paying in foreign currency or making loan payments that are subject to interest rate fluctuations. We show you here how the cash flow hedge works and how it differs from other hedging mechanisms.

Cash flow hedge: Definition

A cash flow hedge protects the cash flow against fluctuations. It is often used when transactions are conducted in foreign currencies in order to hedge exchange rate risks. Cash flow hedges are offered as financial instruments (so-called derivatives) by financial institutions.

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A cash flow hedge freezes the amount of a future incoming or outgoing cash flow at a certain value so that the future cash flow does not exceed or fall below this value.

Cash flow hedge vs fair value hedge

A fair value hedge protects assets or liabilities against fluctuations in value. For example, if a company fears that one of its investments will lose value, it can hedge it.

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The current fair value of the asset is used as a basis and then frozen. If the price of the investment goes down, its value is still preserved thanks to the fair value hedge.

A fair value hedge therefore directly hedges the value of a particular asset, whereas a cash flow hedge hedges the cash flow generated when an asset is bought or sold.

Cash flow hedge: Example

A company needs 1kg of platinum for the production of electronic goods, which currently costs around £30,000. However, it is feared that due to the shortage of raw materials and supply delays, the price of a kilogramme will rise to £35,000.

In order not to incur additional costs, the company wants to hedge its cash flow. It therefore acquires a cash flow hedge contract in which the value of £30,000 is hedged.

Three scenarios can then occur:

  1. Platinum price increases: If the price of platinum at the time of purchase is higher than £30,000, e.g. £35,000, the company pays £35,000 but receives £5,000 back from the hedging contract, so no loss is incurred.
  2. Platinum price falls: Contrary to expectations, the platinum price falls to £25,000. The company pays £25,000 to the supplier and has to add £5,000 to the hedging contract to balance it as it was frozen at £30,000
  3. Platinum price remains the same: If the platinum price does not change, the company pays £30,000 to the supplier without the hedging contract having any influence

As can be seen, the hedging contract only takes effect if the cash flow would actually fluctuate.

Cash flow hedge: Accounting & journal entries

The following steps are necessary to correctly account for the cash flow hedge:

  • Determine loss or gain on cash flow hedge
  • Calculate effective and ineffective portion from cash flow hedge
  • Effective portion of the gain or loss is recognised in OCI (Other comprehensive income)
  • Ineffective portion of profit or loss is recognised as profit/loss

Depending on whether gains or losses and whether these represent effective or ineffective portions of the cash flow hedge, they are accounted for as follows:

Debit Credit
Loss (effective) Other comprehensive income, cash flow hedge reserve Balance sheet, financial liabilities from hedging instruments
Loss (ineffective) Profit and loss account, ineffective portion loss on hedging instruments Balance sheet, financial liabilities from hedging instruments
Gain (effective) Balance sheet, financial assets from hedging instruments Other comprehensive income, cash flow hedge reserve
Gain (ineffective) Balance sheet, financial assets from hedging instruments Profit and loss account, ineffective portion of gain on hedging instrument

Cash flow interest rate swap

In order to hedge interest rate risks in the repayment of long-term loans, a cash flow interest rate swap can be concluded. The swap provider (a bank or financial institution) offers the client compensation for the interest payments so that the client is protected against interest rate fluctuations.

For this purpose, a cash flow is calculated for the interest payment with a fixed interest rate and a cash flow with a floating interest rate. Expressed in a formula, it looks like this:

Total interest expense = Debt floating rate + (Fixed rate - swap floating rate) x loan + swap costs

Debt floating rate is the payment that the borrower has to make to the lender. This includes the interest rate fluctuations, which are offset by the swap provider.

For example, if a fixed rate of 5% was agreed and interest rates rise to 6% (debt floating rate), the swap floating rate would be 6%, so that 1% of the loan payments would be paid out to the borrower again.

This method can also be used to hedge exchange rate fluctuations through a cash flow hedge. Instead of an interest rate, a certain exchange rate is then frozen. However, in the case of both interest payments and transactions in foreign currencies, a company may incur losses as a result of the hedge if interest rates or exchange rates do not develop in the expected direction.

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