Hedging with Interest Rate and Credit Derivatives by Banks

Abstract

This paper empirically investigates two questions. First, what makes a bank hedge in certain periods but not in others? We find that banks are more likely to be hedgers with interest rate derivatives when loan commitment, demand deposit, ROE, size and credit spread are higher; higher interest rate and term spread reduce the likelihood of being a hedger with interest rate derivatives. Higher transaction deposit, larger size and the engagement in the trading of credit derivatives induce banks to become hedgers with credit derivatives. Second, how can the change in a bank's derivatives holding for hedging be explained? While larger increases in Tier-I capital, size, interest rate and credit spread augment the hedging with interest rate derivatives, larger increases in term spread reduces such hedging. Hedging with more credit derivatives is more likely when a bank engages in securitization and the trading of credit derivatives. Detailed interpretations of the empirical results are provided.