The increasing use of derivatives by commercial banks has been the subject of regulatory interest. Hedging through the use of derivatives can be an effective mechanism for controlling risks. However, large commercial banks are using derivatives for trading and, potentially, not for purely hedging purposes. Research examining the consequence of derivatives use on banks' stock return or volatility is limited. The focus of this dissertation is to determine if there are statistically significant risk differences for bank holding companies using derivatives. Systematic and unsystematic risk measurements are used to test for differences in the levels of risk based on two tests. The first test compares the level of risk across portfolios formed on the basis of the percentage of derivatives that are reported as ‘held-for-trading’. The second test compares the level of risk across portfolios formed on the basis of the level of the notional value of derivatives held by the firms. The hypothesis that bank holding companies using derivatives to hedge should have very low or no exposure to price changes underlying the derivative contracts is also tested. Lastly, a pair of hypotheses test whether derivative holdings and bank holding companies' exposure to interest rate and exchange rate risks are related. The results support the hypothesis that the percentage of derivatives held-for-trading and the hypothesis that the size of the derivatives portfolio does have an statistically significant effect on total return volatility but not for systematic risk levels. There is also evidence that large firms using exchange rate derivatives have increased risk which is not consistent with the notion that exchange rate derivatives should hedge their positions.
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