How a CD Hedges Perfectly Against Risky Investments

Post-credit crunch CD rates are contradictorily excellent for investors. Even after infusing the market with billions of dollars worth of capital, personal CD rates are at their best – mostly because the LIBOR rates (the rate at which banks lend to banks) has yet to fall. The only source of capital for banks is other banks in this environment, as only a few have access to government funds. Other smaller and well capitalized banks are finding a tough time finding capital. The general idea that banks are in distress has scared investors away from any significant investments in banks.

Making the Hedge

High CD rates allow for the perfectly hedged investment. First, all money invested in a CD will be fully insured and protected by the FDIC. The only downside to this hedging strategy is that the bank could fail, in which case you’d get your money back, but you would not receive future interest payments. At the same time, rates might even be lower at that point.

Shopping Around for the Best CD Rates

Finding the best CD rates often employs plenty of shopping around and due diligence. Many local banks offer high returns for long term deposits and only advertise their rates to people in the local area. Likewise, credit unions and membership driven banks will only offer the best rates to members as a way to draw new people to the bank. For global types, offers an effective solution for finding the best CD rates.

Make sure to evaluate the bank’s credit rating as a general indicator of its solvency. Some banks like GE money bank or GMAC (the financing arm of General Motors) may not be good institutions to entrust with your money. Even though the banks are FDIC insured, the chance of default (and liquidation of your CD to cash) is greater than others.

How it Works

The hedge is driven almost entirely by the CD. The goal is to find a CD for the timeframe that you would like to hedge against. For example, using a 5 year timeframe, the rates will be better, but you’ll be locked in for 5 years. The general goal is to invest as much as necessary to cover your more speculative investments that are a part of the hedge. With $10,000 and an example APR of 10% for one year, you’d want to invest $9100 into the CD (which will grow to $1010.) The remaining $900 can be invested in whatever you like; think speculative for as long as the CD lasts, as your investment is 100% protected. And in the case of the example above, you would actually make 1% on your investment regardless. Obviously, finding 10% rates in this environment is not easy, but 4% and higher rates on 5 year CDs are entirely possible with many local promotional rates.

Why Use a CD?

In any investing climate, and especially today, protecting your investment capital is the most important strategy. Though you may limit your upside, the downside is negated and the chance of loss virtually eliminated. Furthermore, you’ll also be able to take extremely speculative investments due to the hedge in your CD.

What to Buy

In today’s market, there are hundreds of investments that could pay off tremendously should the economy turn around. Think Ford, GM, the banking sector – any number of stocks that have fallen some 90% from their tops. You also have currency trade options or emerging markets. The possibilities are endless.

A Variant of the Hedge

Since picking the market bottom is impossible when the market is bottoming, this hedge can be used to profit tremendously on the upturn. By operating this hedge every month, or every few months, you could effectively lock in a new CD and take a high risk option play on the turnaround. Look far out into the upper strike prices on an index ETF and aim for the sky. If you miss, you haven’t lost a dime. and if the market continues finding new bottoms, your money was better off in a CD anyway you cut it.

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