Derivatives as risk management and performance of agricultural banks

Abstract

PurposeThe purpose of this paper is to estimate the impact of financial derivatives on profitability in agricultural banks. Agricultural banks are new to the derivatives market and are unlikely to use financial derivatives for risk speculation. Thus, the paper also provides evidence on the effectiveness of financial derivatives as a risk management tool in small commercial banks.Design/methodology/approachThe authors use call report data from Federal Reserve Bank of Chicago for 2006, 2008 and 2010 to estimate an endogenous switching model to evaluate how profitability of derivatives user and non‐user agricultural banks is affected by different risk factors. This approach allows banks' endogenous choices to use financial derivatives to be accounted for, and to build a counterfactual analysis – what user banks' profitability would have been if they did not participate in the derivatives activities.FindingsResults indicate that risk management through financial derivatives in agricultural banks is effective and profitability of derivatives user agricultural banks is less affected by credit risk and interest risk in the sample period. Derivatives' activities have improved agricultural banks' profitability and these impacts were increasing over years. In particular, in 2010 without use of derivatives, user banks would have had one‐third lower profitability.Originality/valueThis research is the first to study the role of derivatives in agricultural banks and also provides empirical evidence on the effectiveness of risk management through financial derivatives in agricultural banks.