What is Hedging in Finance?

Hedging is a risk reduction technique whereby an entity uses a derivative or similar instrument to offset future changes in the fair value or cash flows of an asset or liability. A perfect hedge eliminates the risk of a subsequent price movement. A hedged item can be any of the following individually or in a group with similar risk characteristics:

Highly probable forecast transaction
Net investment in a foreign operation
Recognized asset
Recognized liability
Unrecognized firm commitment

Hedge effectiveness is the amount of changes in the fair value or cash flows of a hedged item that are offset by changes in the fair value or cash flows of a hedging instrument.

Accounting for Hedges

Hedge accounting involves matching a derivative instrument to a hedged item, and then recognizing gains and losses from both items in the same period. The net result of these gains and losses should be relatively small, as long as the hedging instrument was properly paired with the hedged item.