What is Hedge Accounting?
Hedge accounting is a portfolio accounting method that combines the values of both a security and its offsetting hedge instrument.
How Does Hedge Accounting Work?
If investors purchase a security that comprises a high level of risk, they may accompany the purchase with an opposing item (usually a derivative, such as an option or future contract) referred to as a hedge. This hedge experiences gains in value when the corresponding security sustains losses. Under traditional accounting practices, a security and its hedge are treated as separate components when priced. Hedge accounting treats them as a single accounting entry that reflects the combined market values of the security and the hedge.
For example, suppose an investor, Jane, holds 10 shares of stock ABC priced at $10 each, worth a total of $100. To hedge against the stock's price falling, she buys a put option contract priced at $1 per share for 10 shares of stock ABC with a strike price of $8. Under traditional methods, these items and their prices would be recorded independently. Under hedge accounting, they would be recorded as one item. The value of the item under hedge accounting would be the price of the shares plus the market value of the options contract, $100 + $1(10) = $110.
Why Does Hedge Accounting Matter?
Hedge accounting is predicated on the principle that a hedge functions exclusively to offset fluctuations in the market price of a security. For this reason, combining the market prices of both alleviates the effects of price volatility in mark-to-market accounting.