Derivatives and Depository Interest Rate Risk: An Empirical Analysis

Abstract

This paper empirically examines the relationship between the use of on-and-off-balance sheet derivatives and the interest rate risk of US savings associations during 1993-1997. Unlike prior studies, this analysis uses market values, not notional amounts, of all derivatives obtained from the Office of Thrift Supervision?s (OTS) Net Portfolio Value (NPV) Model. The(NPV) model calculates the value of a thrift?s entire portfolio, both on-and-off-balance sheet, to determine each firm?s interest rate risk. We use these data to examine how various factors affect the decision to use or not to use derivatives, whether or not firms use derivatives for hedging. An additional advantage of examining thrifts is that they are end-users of derivatives contracts ? not dealers. The use of derivatives, such as forwards, futures, options, and swaps, by thrifts has not been an industry-wide phenomenon. As of March 1997, only 9.8 percent of savings associations use derivatives. Looking at simple industry averages shows that thrifts using off-balance sheet derivatives, have lower levels of capital, less interest rate risk, and lower net interest margins, than large stock owned-thrifts. However, we also find that thrifts use of derivatives is consistent both with profit maximization and with hedging. After controlling for portfolio and other firm characteristics, we find that thrifts use derivatives to reduce interest rate risk and lessen their vulnerability to capital compliance problems. Further, we find that, after controlling for interest rate risk and credit risk, firms using derivatives have higher net interest margins. We also find that the notable lack of usage by smaller institutions is consistent with rational profit-maximizing behavior as the tendency to avoid derivatives by small institutions is far more pronounced for dealer market products, such as swaps (where low transactions costs can only be obtained by large players), than for exchange-traded products, such as futures. Nevertheless, the lack of derivatives use by most thrifts suggests that a significant segment of the industry is limited in the way it manages interest rate risk.