Bank hedging in futures markets: an integrated approach to exchange and interest rate risk management

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Virginia Tech

This study investigates the simultaneous use of interest rate and currency futures markets to hedge the exchange and interest rate risks faced by banks. Banks in this study accept short-term variable rate deposits, hold many different foreign currencies, and make long-term fixed rate loans. The expected utility maximization model shows that in a two-period framework the bank’s optimal simultaneous hedge ratios for risks associated with exchange rate, interest rate, and anticipatory positions are given by the coefficients of the theoretical multivariate multiple regression of returns from trading the (spot) instruments being hedged on those from trading the futures contracts. Unlike previous studies, capital adequacy is shown in this study to be an important factor determining the bank’s optimal futures position. The bank’s decisions on loan extensions and interest rate futures positions are shown to be affected by the existence of foreign exchange operations and the availability of foreign currency futures contracts. It is also shown that the (optimal) hedging decisions anticipated for later time periods influence current decisions, which implies that hedge positions are intertemporally dependent.

Based on the theoretical analyses, five testable hypotheses are derived: (i) Capital adequacy irrelevance hypothesis, (ii) Naive-single market hypothesis, (iii) Own market hypothesis, (iv) Intertemporal position irrelevance hypothesis, and (v) International banking hypothesis. These hypotheses are tested using the generalized method of moments procedure. The empirical results show that (a) capital adequacy is highly relevant for the bank’s decision on optimal futures positions, (b) it is not optimal for the bank to take a naive position in the corresponding futures contracts to hedge a specific type of spot position, (c) cross-hedging is necessary to increase hedging performance, (d) the bank’s anticipated positions in foreign currency spot and futures contracts next period affect the current decisions on optimal spot and futures positions, and (e) international banking activity, as it is interrelated with domestic and international credit markets, must be considered when the bank makes decisions on optimal futures positions. Finally, the optimal hedge ratio estimates demonstrate strong evidence that banks should use the futures markets to a substantially greater extent for hedging overall market risk compared to when they hedge each component of market risk separately.