Ashlin Minogue M.A. Senior Manager and Content Writer
Oct 01, 2023 · 2 min read · AICPA & CIMA Insights Blog
Hedging is a popular approach to investing and a known strategy to limit financial risk.
One tactic is to take a risk position opposite to a related asset that is exposed to risk, thereby offsetting investment losses. An investment that will appreciate when your primary investment depreciates, or vice versa, hedges overall losses.
Hedging strategies typically involve derivatives — options, futures, and forward contracts — but hedging can come in other forms, including pairs trading, trading safe haven assets, and asset allocation.
For many organizations, including credit unions, changes to the regulatory environment make now the right time to implement hedging strategies. Hedging can be an effective risk management strategy because it provides better stability when future costs are uncertain.
“In an ever-dynamic interest rate environment, hedging is an effective risk management tool that can provide better stability when costs are uncertain,” said Jason Brodmerkel, CPA, Senior Manager, Accounting Standards, AICPA® & CIMA®, together as the Association of International Certified Professional Accountants.
This October, Ryan Henley, CFA, Managing Director, Head of Financial Institutions Strategies, Stifel Fixed Income’s Financial Institutions Strategy Group, will share professional insights and tactics for implementing hedging strategies for credit unions at the AICPA & CIMA Conference on Credit Unions.
Hedging to mitigate risks
The primary reason for hedging is risk management: attempting to mitigate the extent of potential losses. Rather than closing an existing trade that could move in an undesirable direction, choosing to hedge (e.g., take the offsetting position in an asset) may mitigate potential losses. Although hedging reduces the likelihood of loss, it also reduces the significance of prospective profits.
Hedge relationships can also be constructed with derivative strategies. Financial institutions often use derivative financial instruments, including commodity risks, foreign exchange risks and interest rate risks.
For example, a short-term loan with variable interest exposes the organization to interest rate risk. Forwards, futures, and options could be used to safeguard against the effects of changing interest rates. Interest rate swaps — a large component of derivatives — are used to hedge risks because interest rate swaps and interest rate caps facilitate the maintenance of core assets. With interest rate swaps, floating rate payments can replace fixed interest payments (or fixed payments can be exchanged for floating payments) without affecting the underlying principal amounts.
Henley will dive into techniques about how institutions use hedging strategies to reduce interest rate risk and cost of funds to achieve strategic objectives.
Hedging to achieve organizational objectives
A goal of hedging is to provide greater certainty of future costs, which is appealing to organizations of all sizes in business and industry.
“Using hedging as a tool, especially during an uncertain interest rate risk environment, can provide greater clarity to numerous organizational costs, including the cost of debt service. Ultimately, this is extremely appealing to overall organizational initiatives to help plan for the future, such as forecasting and budgeting,” Brodmerkel noted.
If your credit union seeks to implement hedging as a technique for achieving strategic initiatives, you’ll want to establish policies and procedures for your organization. To kick-start your efforts, Henley will provide real-world examples with practical considerations. He will articulate techniques for implementing hedging, including how to 1) build a team to initiate and monitor hedging processes; 2) clarify messaging to the organization; and 3) incorporate key components of policy development.
The AICPA & CIMA Conference on Credit Unions is an ideal opportunity to learn more about hedging and other advanced technical content that directly relates to your unique daily work. Join us in Denver, Colorado or live online Oct. 23–25.
