Accounting for corporate finance: hedging: fair value hedge
This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.
Fair value hedges
The examples below are of fair value hedges. For the definition of a fair value hedge see CFM27120.
A company borrows £10 million at a fixed interest rate of 8%. Its cash flows will not change as it will pay a fixed £800,000 interest a year. However, the fair value of its liability will change as interest rates move. It can hedge its exposure to fair value changes by entering into an interest rate swap, under which it receives fixed rate payments and pays floating rate.
A chocolate manufacturer enters into a contract to buy 5,000 tonnes of cocoa beans at a fixed price in six months’ time. The company knows what its future cash flow will be. But the fair value of this firm commitment will change as the price of cocoa beans changes (even though the commitment won’t be shown on the company’s balance sheet). The company could hedge the changes in fair value by entering into a futures contract over cocoa beans.
Under IAS 39, it is necessary to be clear about the particular risk you are hedging. In the second example, if the company (which accounts in sterling) had a contract to pay for the cocoa beans in US dollars it would, in addition to the commodity price risk, be exposed to foreign currency risk. Any hedge of the currency risk would need to be considered separately. Fluctuations in exchange rates will affect both the fair value of the firm commitment, and the actual sterling amount the company must pay - so a hedge of the foreign currency risk could be either a fair value hedge or a cash flow hedge).