1. Core Structural Definition of a Derivative
Under both frameworks, a derivative is a financial instrument or other contract that satisfies three criteria:
- Its value changes in response to changes in a specified variable (such as an interest rate, commodity price, or foreign exchange rate, known as the “underlying”).
- It requires no initial net investment, or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to changes in market factors.
- It is settled at a future date.
2. Fair Value Hedges vs. Cash Flow Hedges
Hedge accounting changes the timing of when gains or losses on a derivative are recognized to match the timing of when the offsetting changes in the value of the hedged item affect profit or loss.
- Fair Value Hedge: A hedge of the exposure to changes in the fair value of a recognized asset, liability, or unrecognized firm commitment. Gains or losses on both the derivative and the hedged item are recognized simultaneously in profit or loss.
- Cash Flow Hedge: A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or part of a recognized asset, liability, or highly probable forecast transaction. The effective portion of the derivative’s gain or loss is recorded in OCI (Hedge Reserve) and recycled to profit or loss only when the hedged transaction impacts the income statement.
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