Toward an optimal hedging strategy considering earnings volatility through fair value accounted financial derivatives

The purpose of this paper is to determine a financial institution's optimal hedging degree under consideration of costly earnings volatility induced by fair value accounted derivatives. The discussion on the adoption of fair value accounting in the financial industry has been rather controversial in recent years. Under this accounting regime, the change in market values of specific assets must be considered as profit or loss. Critics argue that fair value accounting induces higher earnings volatility compared to historical cost accounting and, therefore, may initiate a downward spiral during recessions. Thus, increased earnings volatility induces costs, which can be explained by disappointed capital market expectations. Consequently, in general, a lowering of earnings volatility will be rewarded. Consistent with this theoretical finding, empirical research provides strong evidence that companies pursue income smoothing to reduce earnings volatility. In contrast to industrial corporations, financial institutions may easily reduce their earnings volatility by engaging in additional hedging activities. However, more intense hedging usually reduces expected profits.

Based on a research project initiated by a large German bank, this study quantitatively models the trade-off between the (utility of) costs of earnings volatility and the reduction of profit potential through additional hedging.

By conducting sensitivity analyses and simulations of the crucial factors of the trade-off, we examine relevant causal relationships to obtain first indications about the economic benefits of income smoothing.

To the best of our knowledge, we are the first to develop an optimization model that supports decision-making by attempting to determine an optimal (additional) hedging degree considering the costs induced by earnings volatility.