A derivative may be used to avoid the exposure to risk by hedging against an unfavorable outcome associated with rate/price changes. Hedges are classified as either fair value or cash flow.
A fair value hedge is used to offset changes in the fair value of items with fixed prices or rates. Fair value hedges include hedges against a change in the fair value of
- A recognized asset or liability.
- An unrecognized firm commitment.
A cash flow hedge is used to establish fixed prices or rates when future cash flows could vary due to changes in prices or rates. Cash flow hedges include hedges against the change in cash flows associated with
- A forecasted transaction.
- An existing asset or liability with variable future cash flows.
Derivative instruments are frequently used as hedges with respect to the exposure to risk associated with foreign currency transactions and investments in foreign companies.