This study develops several empirical tests of the rationales for corporate risk-taking and risk-management activities. The theoretical literature on corporate hedging has demonstrated how widely-held large corporations may hedge in order to: (1) reduce the expected costs of financial distress, (2) decrease other costs such as those associated with agency problems and asymmetric information, and (3) increase the expected level of after tax cash flows (e.g., via a reduction in taxes as well as through lower transaction and contracting costs). The tests of these theories are conducted on a sample of 241 publicly traded bank holding companies in the U.S. during 1991–1995. Pooled ordinary least squares, a simultaneous equations framework based on a generalized method of moments estimator, and confirmatory factor analysis are employed to account for potential econometric problems related to omitted variables, endogeneity, and errors-in-variables. Five main results emerge from the analysis: (1) the risk-management theories most consistently supported are those related to managerial contracting and hedge substitutes (e.g., the dividend pay-out ratio), (2) an empirical model of corporate risk-management provides greater explanatory power of a bank’s total risk rather than its interest rate risk, (3) four fundamental risks related to credit quality, interest rate exposure, operations, and liquidity appear to be determined simultaneously, (4) the econometric problems noted above suggest the use of a simultaneous equations framework is more appropriate than pooled ordinary least squares, and (5) the analysis identifies the main observable characteristics affecting the riskiness of bank holding companies.
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