Which type of hedge is used to mitigate risks associated with cash flows?

• A. Fair value hedge
• B. Foreign currency hedge
• C. Cash flow hedge
• D. Net investment hedge

Answer: (C)

A cash flow hedge is specifically designed to mitigate risks related to fluctuations in cash flows associated with recognized assets or liabilities, as well as forecasted transactions. This type of hedge allows a company to protect itself against variability in cash flows that might occur due to changes in interest rates, foreign exchange rates, or commodity prices.

For example, if a company expects to receive cash flows in the future from sales that are denominated in a foreign currency, it may use a cash flow hedge to lock in exchange rates and stabilize its expected cash inflows. This hedging strategy provides a level of predictability and helps a company to manage its exposure to potential adverse changes in those cash flows.

Other types of hedges serve different purposes. A fair value hedge addresses the risk of changes in the fair value of an asset or liability, while a foreign currency hedge can involve either cash flow or fair value hedging strategies related to foreign currency risks. A net investment hedge is used mainly to manage the risk associated with net investments in foreign operations. Thus, the cash flow hedge is distinct and specifically focused on stabilizing cash flows, making it the correct answer in this context.