Bank Risk, Financial Stress, and Bank Derivative Use

Abstract

This paper distinguishes hedging from speculative derivative usage by U.S. bank holding companies (BHCs). This is accomplished by implementing a multi-step procedure that relates the implied volatility from traded options on these banks, broad components of the Cleveland Fed Financial Stress Index, and off-balance sheet derivatives. Our results indicate that BHCs with positive risk exposure to various financial stresses generally use interest rate, foreign exchange, equity, commodity, and credit derivatives to reduce their risk exposure to these financial stresses. Additionally, positively exposed BHCs that use credit and equity derivatives to reduce interbank stress risk have stock performance that bests that of BHCs which do not use such derivatives.