Question

What is the point of hedging (as a broader concept) and how is that different from diversification?

- What is the point of qualifying for hedge accounting, and what do you have to do to qualify? Though the rules of hedge accounting may be different based on what you are hedging against (fair value vs. cash flow), what is the overall purpose of qualifying for hedge "accounting"?

Answer 1

Hedge is akin to purchasing an insuranc against a specific event or unfavourable price movement where as the diversification is investing into uncorrelated or low correlated assets to lower the return/income variability. In general hedge would be short term in nature (though there are multi year hedges also but they are also executed in parts) and diversification is strategic and more long term in nature. Also hedge by nature is linked to an underlying asset for which downside protection is required and on its own as a stand alone investment it will not ne considered.

To quailfy a hedge in accounting - the instruments used should be elgible for hedge accounting and there should be an economic relationship between the asset being hedged and the hedging instrument like a US Dollar inflow and forward exchange rate to hedge it. At the time of hedging the hedge ratio, purpose and risk should documented and the risk emanating from the hedging instrument should be such that it over shadows the asset being hedged.