Bank Risk, Implied Volatility and Bank Derivative Use: Implications for Future Performance

Abstract

This paper attempts to distinguish hedging versus speculative derivative usage by U.S. bank holding companies, and whether that has implications for future performance. This is accomplished by implementing a multi-step procedure that relates the implied volatility from traded options on these banks, macroeconomic factors, and off-balance sheet derivatives. Our results indicate that the relationship between risk sensitivity and derivative usage is strongest for interest rate and foreign exchanges activities. Additionally, we demonstrate that speculators outperform hedgers in managing interest rate risk but underperform hedgers in managing foreign exchange risk (US/JPN). There is little difference in performance for the other derivative products, but this is not surprising since the value of these derivative positions are small by comparison.