Effects of Derivatives on Bank Risk

Abstract

This study investigates the empirical relationship between the use of derivatives by Korean banks and risk. In doing so, we employ two alternative measures of proxy for firm risk: systematic risk and ex ante earnings volatility. Contrary to the general concerns about the risk-increasing role of the use of derivative products, our results indicate that banks' derivatives are, on average, associated with two measures of risk in negative ways. The evidence is consistent with the conjectures that derivative use reduces noise related to exogenous factors and hence decreases firm risk. This suggests that equity market participants, on average, perceive derivative activities by banks as a sign of banks' efforts to reduce risk.