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.
Hedge accounting involves matching a derivative instrument to a hedged item, and then recognizing gains and losses from both items in the same period.