Can hedging instrument be a non-derivative
A hedging instrument should necessarily be a derivative. Do you agree?
Hedging instrument need not necessarily be a derivative instrument even though mostly derivative instruments are used as hedging instruments. The key feature of a derivative instrument should be that it should help minimise the risk which it seeks to hedge. The hedging instrument should not result in taking additional risks or exposures. In other words, it should have a limited risk while having a potential to make significant gains. Normally, the hedging instrument is a purchased option based derivative contract which has a very limited risk, but at the same time, enables the entity to achieve significant gains. When a non-option based derivative contract is used as a hedging instrument, it is usually to peg the rate of a non-existing item at that point of time, eg, an entity may enter into a futures contract to sell its inventory at a future date say, six months from now, so as to peg the rate at which the entity can realise its revenue. The reason for entering into the futures contract is due to the fact that the entity does not have the inventory at that point of time but will procure or purchase subsequently before the date of expiry of the futures contract. A non-derivative contract also can be used as a hedging instrument where the risk of hedging is relating to the foreign exchange risk in respect of a liability payable or receivable in foreign currency. For example, an entity can designate a liability in foreign currency as a hedging instrument to hedge a receivable in the same foreign currency.