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What Is a Fair Value Hedge?

A fair value hedge is a financial strategy used to mitigate risks associated with asset or liability price fluctuations. By using derivatives like futures or options, investors can lock in prices, effectively neutralizing potential losses. It's a savvy move for those aiming to protect their investments from market volatility. How might this approach fit into your financial plan?
A. Leverkuhn
A. Leverkuhn

A fair value hedge is a type of financial strategy that involves using a financial product, usually a derivative, to hedge against risk from price changes in an asset. Investors and traders use fair value hedges to hedge against changes in fair value, or market value, of assets or liabilities. The fair value hedge is just one kind of hedge that companies and other parties use to balance their books against risk.

In a fair value hedge, the hedge instrument is working against market value changes. One example is a fixed rate bond and its market value. Derivatives that are set up to balance against changes in the bond’s price would be said to constitute fair value hedges.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

Sometimes, a company can issue debt, and use the hedge to balance out changes in the value of that debt. Various financial professionals refer to bonds or other debts and their corresponding hedge instruments, as “balancing each other out” on a ledger. Some professionals would use the term “net position” to describe similar hedges practiced by individual traders or investors.

An alternative kind of hedge to the fair value hedge is called a cash flow hedge. This kind of hedge is used differently from the fair value hedge in corporate accounting. The end result of a cash flow hedge is balancing the market rate changes into a fixed rate of interest expense.

When executing a fair value hedge, those who are establishing these market strategies need to keep an eye on all applicable national laws in the country where they operate. For international companies, some international rules may also apply. The respective governments of nations set specific corporate accounting standards and principles for companies that use these complex vehicles to balance out risk, and control their overall positions with regard to assets or debt.

Other rules on fair value and cash flow hedges may apply to the use of derivatives in foreign markets, where the original asset was attained through Forex trading. Derivatives sold on Forex markets may be said to constitute a “Forex hedge,” and come under other rules. Those using hedges should understand how Forex, or foreign exchange, hedges are handled in a specific country or region of the world.

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