How do fair value hedge entries differ from cash flow hedges?

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AcadiFi · Accepted Answer

Fair value hedges run both the derivative and the hedged item through P&L immediately, producing an offset in current earnings rather than deferring gains in OCI. Meridian owns a $10M fixed 5% bond classified as AFS and enters a pay-fixed/receive-floating swap to convert it to floating. If rates rise, the bond fair value drops $320,000 and the swap gains $315,000. Entries: Dr. Loss on Bond 320,000 / Cr. Bond Carrying Value 320,000 (adjusting the basis, not OCI as usual for AFS). Dr. Derivative Asset 315,000 / Cr. Gain on Swap 315,000. The $5,000 ineffective portion naturally flows through P&L. ```mermaid flowchart LR A[Fair Value Hedge] --> B[Adjust Hedged Item
to Fair Value] A --> C[Mark Derivative
to Market] B --> D[P&L] C --> D ``` Key difference from cash flow hedges: FV hedge adjusts the carrying value of the hedged item (departing from normal accounting — for AFS bonds, changes would otherwise bypass P&L). Cash flow hedges leave the hedged item alone and defer derivative gains in OCI. Candidates must recognize the hedged risk type: exposure to changes in fair value of a recognized asset/liability (FV hedge) versus exposure to variability in future cash flows (CF hedge). A fixed-rate bond has fair value risk; a floating-rate bond has cash flow risk.

How do fair value hedge entries differ from cash flow hedges?

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