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Mitigation of Risks Associated With Derivatives

Several business entities and financial institutions utilize derivative financial instruments for hedging their exposure to various risks (for instance commodity risk, foreign exchange risk and interest rate risk). Accounting for derivatives and hedging according to the International Accounting Standards requires all the derivatives to be marked-to-market. Moreover, the changes in mark-to-market must be taken to profit and loss account. For several organizations, this can lead to a considerable amount of volatility in profit and loss arising due to the use of derivatives. Any organization is capable of mitigating the effect of profit and loss that arises from the use of derivatives.

Accounting for derivatives and hedging provides an offset to mark-to-market fluctuations of derivatives in profit and loss account. If a hedge relationship is efficient, majority of mark-to-market derivative volatility would be offset in profit and loss account. Moreover, this type of accounting also needs a large quantity of compliance work which involves the documentation of hedge relationship. Simultaneously, the hedge relationship needs to be proved effective, both prospectively as well as retrospectively.

Derivatives which fulfill the criteria for an efficient hedge can be considered for special accounting treatment. In general, there are three kinds of hedges. These include cash flow hedges, fair value hedges as well as hedges for net investment in foreign operations. Let us examine the hedges one by one.

Derivatives could be utilized for hedge changes in the market value (fair value) of liabilities or financial assets such as debt securities. As an example, the market value of a fixed rate bond changes with a fluctuation in interest rates. Therefore, hedging the price risk of the bond with a derivative is regarded as a fair value hedge. The changes taking place in fair value of a derivative flows directly to income statement. However, the changes are offset by the changes taking place in fair value of hedged items that are simultaneously recognized in income statement.

The derivatives are also utilized for hedging changes in the future cash flows. These changes are caused by the existing liabilities or assets or due to projected transactions. In case of a cash flow hedge, the changes in fair value of interest rate swap get accumulated in statement of comprehensive income. A part of the losses and gains is transferred from the comprehensive income to the income statement upon payment of interest on hedged debts. Therefore, the net result is a fixed rate of interest expenditure.

The organizations are also allowed to hedge the foreign currency exposure associated with an investment in foreign operations. Like cash flow hedges, the gains or losses of translation on hedge and the investment are reported in statement of comprehensive income.