Managerial Incentives and the Use of Foreign-Exchange Derivatives by Banks

Abstract

This paper investigates the effect of managerial incentives on the use of foreign-exchange derivatives by U.S. bank holding companies, as end users, over the period 1996-2000. Our data from 252 large bank holding companies allow us to separate derivatives used for purposes other than trading from derivatives used for trading. This unique data set permits the investigation of derivative use in a hedging framework without the elimination of large dealer firms. Additionally, we employ a model suggested by Cragg (1971) that facilitates the examination of the factors underlying the likelihood a firm will use derivatives and the magnitude of foreign-exchange derivatives utilization. We find that managerial incentives determine the decision to use derivatives to hedge, but once managers decide to hedge, firm-specific risk factors determine the amount of derivatives used.