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Hedge accounting is a practice that allows the change in the value of a financial instrument, such as a mortgage, to be offset by the change in the value of the corresponding hedge.
Ordinarily, the hedge might be accounted for at fair value – with all changes appearing as profits or losses – while the hedged item might be accounted for on an accrual basis. If hedge accounting is not applied, there can be significant volatility in earnings even if there is a good real-world offset between the two.
The argument for hedge accounting, then, is that it more accurately reflects the economic reality and avoids misleading investors. The argument against is that, if applied too broadly, it could allow firms to hide gains or losses. As such, strict rules are set on when hedge accounting can be applied – and many derivatives users insist their hedging strategies comply with these rules.
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