FAR- please explain Hedges & Derivatives

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  • #2213428
    Ralphie Dos Nachos
    Participant

    kind of confused in terms of the logic. if someone can explain this to me like I’m 5 that’d be great.

    FAR - 76

    AUD - 89

    BEC - 84

    REG - 86

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  • #2213644
    taylor1
    Participant

    Hedges are derivatives that are specifically used to hedge (or protect) against unfavorable changes in an investment or liability. While a derivative has to meet certain criteria as far as how it's being used by the company in order to be treated as a hedge, all derivatives are similar in that they derive (hence the name) their value from something else… they aren't valuable in and of themselves, they're only valuable because of what happens with something else (i.e.: fluctuations in foreign currency, changes in the prices for wheat, etc.) You can almost think of them like bets or gambles on whether a certain item will increase or decrease.

    In the case of a hedge, the company is buying the derivative because they are concerned that something (like a foreign currency) will change in value and cause unpredictable losses. Hedging (in theory) takes away this risk by making sure that the derivative that's purchased responds oppositely to the factors that would cause the loss. This ultimately causes a net $0 or very small gain/loss for the company. While the company loses the chance they'll experience significant gains due to these fluctuations, they're also protected from losses.

    If the derivative doesn't meet the criteria to be a hedge, it's basically just used for speculation (essentially, the business term for gambling :). It took a while for this to click for me, but I found watching some Investopedia videos on YouTube to be helpful since they helped explain the logic for how these work in the real world. CPA prep books/videos are great, but sometimes they can be too conceptual when I've never even heard of a topic before since I can't visualize how it's actually used. Anyway, sorry for the super long response – I hope it helps!

    FAR - 94 (11/26/18)

    REG - 91 (12/10/18)

    BEC - 94 (2/23/19)

    AUD - 98 (3/9/19)

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