Cash flow hedge
What is a cash flow hedge?
A cash flow hedge is a financial transaction that is designed to protect an individual or company against a risk that would negatively impact cash flow. It is constructed in order to secure the expected cash flow despite an adverse movement in the market.
Where have you heard about cash flow hedges?
As an investor, you may have read about cash flow hedges in the reports of companies whose stock you own. Your financial adviser may mention cash flow hedges, as may reports in the financial media.
What you need to know about cash flow hedges...
Many business operations base their planning on assumptions about market conditions that cannot be guaranteed. These include commodity prices, interest rates and foreign exchange rates. Should any of these move the 'wrong' way, then cash flow and, ultimately, profits could well be affected.
Cash flow can be hedged by taking a position that would compensate for such an adverse movement. In a very simple example, a bakery's cash flow may be reduced if the price of a given quantity of wheat rises from $50 to $60, so the bakery buys a call option allowing it to buy the wheat in that quantity at $50. The same principle works in reverse, with cash flow hedging protecting against price falls.
Find out more about cash flow hedging...
Cash flow hedging is a specific type of hedging. Learn more about the general subject of hedging here.