[inviteyou]

I came across this answer and though I could’ve answered but when I read the answers I got totally confused. Can anyone explain the answer set in English? I’ve read over the material and just get frustrated. Are there any tips for understanding this?

If a company that is not a public business entity wants to apply the simplified hedge accounting approach to a cash flow hedge of a variable rate borrowing with a receive-variable, pay-fixed interest rate swap, which of the following is a condition that must be met? The correct answer is D.

A. The notional value of the swap is greater than the principal of the hedged borrowing.
B. The fair value of the interest rate swap executed has a value equivalent to the hedged borrowing.
C. The variable interest rate on the interest rate swap is capped at 250 basis points above the cap on the hedged borrowing.
D. The variable interest rate on the interest rate swap and the variable interest rate on the hedged borrowing are linked to the same index.

[jombe]

Try to get an understanding of what hedging is.
When you hedge, you are hedging a risk. Generally, a company would “hedge” a contract by entering into futures market that's linked to same commodity.
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Let's say you are selling wheat and you entered into a contract to sell 100 bushels in 3 months at $1.00/bushel.
The risk here is wheat price going up from the time you entered into the contract and to the time of delivery.
In 3 months, if wheat price went up to $1.50, you are losing out on $0.50/bushel. So you go to futures market and go “Long” or “Buy” position. If you “buy” a futures contract and hold it til delivery and if the price went up to $1.50/bushel, now you sell your futures contract and make $0.50/bushel. This would cancel out the loss you incurred on the contract you entered into 3 months ago.
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Long story short, you can't hedge gold w/ silver. You can't hedge wheat w/ corn. They all have to be of same nature, since hedging is really just going the opposite direction of what you are trying to hedge.

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[inviteyou]

Ok, thank you. That makes sense now. Would you have an example of a cash flow hedge of a variable rate borrowing with a receive-variable, pay-fixed interest rate swap?

If I may, another thing I'm not clear on is the actual transactions of a forward/futures contract. Sticking with your example, I enter into a contract to sell 100 bushels in 3 months at $1.00/bushel to a Company A. On May 12, I sell the bushels and collect $100. However, in the meantime, for example, next week I buy a futures contract, how much do I pay for that futures contract? And, what am I paying for? Am I paying an amount to purchase 100 bushels in 3 months at 1.00/bushel? So now I have a contract to sell to Company A but I also have a contract to buy 100 bushels in 3 months. That's the part that's confusing to me and wouldn't make sense. So is it I am only paying the difference to the person on the other side of the contract for the increase, which would be my loss?

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