Cash flow hedge is an investment method used to control and mitigate any sudden change in either cash inflow or cash outflow of an asset/liability/forecasted transaction. Sudden change is due to various reasons like change in interest rate, change in prices, fluctuations in foreign exchange rates. Transaction with another party on a future date is called a forecasted transaction.
Cash flow hedge should terminate, when
Let’s say a buyer wants to buy 150 tonnes of steel at $1500 per tonne as per current market from a company S.
Now the buyer spent $225000 as per current market rate. But the market conditions are saying that steel prices may go up to $2000 per tonne. As per the future market rate $300000 and this is $75000 more.
To avoid additional expenses, buyers may forward contracts with company S. Even though there is a raise in future, net payment will be the same.
It is the exposure to variability in cash flow of specific forecasted transactions which is attributed to particular risk or in other word this method deflect sudden changes that occurs in either cash outflow or inflow.
This method is more useful for manufacturing or services firms who buy their material regularly. Cash flow hedge is more important where there is a sudden change that impacts cash inflows or cash outflows.