A derivative is a financial product that, as the name indicates, is derived from another financial product, such as a security, whose value changes. One of the most common kinds of derivatives is the interest swap, in which two parties agree to swap cash flows from two different interest-generating assets. Often an investor will purchase a derivative as a hedge against a particular investment. Cash flow and fair value hedges are two types of this derivative.
Cash Flow Hedges
A cash flow hedge is a hedge derived from cash flows received from two or more financial products. For example, the hedge may be linked to the cash flows generated by a bond, one that provides payments of interest to investors. If the interest rate shifts, affecting the size of the cash flow, then the value of the bond shifts. Cash flow hedges can protect against these shifts.
Fair Value Hedges
A fair value hedge is a hedge against an asset with a fixed value that changes according to supply and demand. For example, an investor may choose to purchase a hedge against changes in the value of a stock. This would be a fixed-value hedge, as the stock does not provide a regular cash flow -- unless it distributes dividends to its shareholders.
The main difference between a cash flow and a fixed-value hedge is that only one is linked to an asset that provides regular payments to the holder -- the cash flow hedge. While both are used to hedge against changes in the value of the asset, the cash flow hedge is more often tied to changes in one or more types of interest rates.
Evaluating a particular hedge, whether cash flow or fair value, can be a challenge. This is because the value of the derivatives depend greatly on factors that cannot yet be predicted, such as future interest rate changes. This presents problems to accountants. While both cash flow and fair value hedges are accounted as mark to market, only cash flow payments are marked in statements as interest on hedged debt.