| The goal of this dissertation was to gain insights on the purpose, benefits, and risks of derivatives usage by large bank holding companies. Widely publicized cases of significant losses involving derivatives have raised public concern over the use of derivatives. Warren Buffett stated that, "derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." Rene Stulz concluded that risks of using derivatives can be measured and managed well at the firm level. Such risks are so critical to an individual bank holding company's financial health and the functional well being of our financial markets and overall economy that Stulz's conjectures need to be tested empirically.; This dissertation employed research designs, data, and statistical tests that corrected for the limitations of previous studies by assessing the impact of bank usage of derivatives on overall bank risk through the simultaneous inclusion of interest rate, exchange rate and basis risks; new risk and control variables; recent, more representative data; improved sampling; bank-specific motivations; and macro-economic conditions. This is the fist formal, rigorous research effort that related bank characteristics to the propensity to hold derivative contracts for trading as opposed to purposes other than trading.; Banks were significantly exposed to exchange rate and basis risks during 1995--2002, but not to interest rate risks during 1999--2002. The largest BHCs had the most exchange rate risks, followed by successively smaller BHCs. Derivatives usage reduced significance and magnitude of most of the on-balance sheet items. Derivatives usage was associated with current credit exposure as well as changes in potential risk exposures and was significantly related to the extent of derivatives held for trading. Derivatives trading by dealer BHCs seemed to be for proprietary reasons, resulting in a significant increase in the current credit exposure as well as liquidity exposure, while potential exposure declined. Other BHCs seemed to have used derivatives largely for hedging. Overall, it appears that, over the sample period, large bank holding companies have done a reasonably good job, in measuring and managing their risks due to derivatives usage. However, the results revealed some disturbing trends with potential consequences for future risks. |
