A hedge that accounts for the changes in the fair value of a recognized asset or liability or that of an unrecognized firm commitment, that results from a specific risk.
Fair value hedges involve the use of derivatives. For example, for a recognized liability, fair value hedge can be established using swaps (variable for fixed- floating for fixed swaps). For an unrecognized firm commitment, a forward foreign exchange contract is typically used.
The need for fair value hedges arises in situations that involve foreign exchange transactions. An example is a company that makes a firm commitment with a supplier in another country for the purchase of a piece of machinery at a future date. This means, delivery and payment will take place at that date, not now, which in turn leaves the company with an exposure to currency fluctuations between commitment date and payment date. For that reason, it needs to hedge against this unrecognized firm commitment over the course of that interval. For the period between delivery date and payment date, the company has to hedge against a recognized liability (the price of machinery).
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