The effect of derivative instrument use on capital market risk : evidence from banks in emerging and recently developed countries - Mohamed-Rochdi KEFFALA (Université Lyon 1, Laboratoire SAF) - Christian DE PERETTI (Université Lyon 1, Laboratoire SAF) - Chia-Ying CHAN (Yuan Ze University, Taiwan) 2011.8 (WP 2145) Laboratoire SAF – 50 Avenue Tony Garnier - 69366 Lyon cedex 07 http://www.isfa.fr/la_recherche
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The effect of derivative instrument use on capitalmarket risk : evidence from banks in emergingand recently developed countries
- Mohamed-Rochdi KEFFALA (Université Lyon 1, Laboratoire SAF)- Christian DE PERETTI (Université Lyon 1, Laboratoire SAF)- Chia-Ying CHAN (Yuan Ze University, Taiwan)
2011.8 (WP 2145)
Laboratoire SAF – 50 Avenue Tony Garnier - 69366 Lyon cedex 07 http://www.isfa.fr/la_recherche
1
The Effect of Derivative Instrument Use on Capital Market
Risk: Evidence from Banks in Emerging and Recently
Developed Countries
Mohamed Rochdi Keffala 1 *, Christian de Peretti 1, Chia-Ying Chan 2
1 Laboratory of Actuarial and Financial Sciences (SAF, EA2429), Institute of Financial and Insurance
Sciences (ISFA School), University Claude Bernard Lyon 1, University of Lyon, France.2 Department of Finance, College of Management, Yuan Ze University, Taiwan.
Abstract
This study investigates the use of derivative instruments by banks in both emerging
and recently developed countries in terms of capital market risk. Overall, the results
indicate that the use of options increases total return risk and unsystematic risk, while
the use of forwards and futures decreases total return risk. Swaps, in the meantime,
negatively affect systematic risk. The main conclusion is that banks in the sample do
not appear to be at risk by using derivative instruments.
Moreover, the dramatic rise in the number of futures contracts from 2002 to 2009 on
the Bursa Malaysia exchange is shown in Figure 4.
Source: www.bursamalaysia.com
Figure 4. Growth of Futures trading contracts in Malaysia
Thus, as shown, with the obvious increase and expansion of derivative instruments
usage in both emerging and recently developed countries during the last decade, it is
important to study the effects that these financial activities have had on banks and
other financial institutions, particularly because of the linkage and connections that
have been made in terms of derivatives and the recent financial crisis.
2.2. Derivative activities and risks: a literature review
In their study of derivatives, Bali, Hume and Martell (2004) demonstrated that
credit derivatives had no significant effect on interest rate exposure. In contrast,
Bartram et al. (2008) deduced that the use of credit derivatives actually decreased
both the total risk and the systematic risk of firms. Additionally, Chung (2002) found
that the use of derivatives decreased corporate risk. Furthermore, Hentschel and
Kothari (2001) also concluded that those who made use of derivatives experienced
less risk than those who used other types of securities or investments. The results of
Nguyen and Faff (2002) indicated that currency derivatives reduced the exchange risk
of firms. However, more recently, Clark and Mefteh (2010) found that the
7
relationship between foreign currency derivatives use and foreign currency exposure
was limited.
Again, the literature concerning the effects of derivatives on bank risk is also
quite limited. The study undertaken by Chaudhry et al. (2000) on US commercial
banks revealed that the use of options tended to increase all types of bank risk for U.S.
banks. However, in contrast, the same study not only found that swaps had a negative
effect on bank risk, but also, the effect of forwards on bank risk was insignificant. In
addition, Reichert and Shyu (2003) found that the use of options increased the interest
rate beta for all US, European and Japanese banks, while both interest rate and
currency swaps generally reduced risk.
In another study, which focused solely on credit derivatives, Instefjord (2005)
deduced that credit derivatives increased bank risk in England. Recently, and without
splitting derivatives by instruments, Yong et al. (2009) found that the use of
derivative activities increased long-term interest rate exposure and decreased short-
term interest rate exposure of Asia-Pacific banks.
In addition, several unpublished papers have also investigated the effects of
derivative instrument use on different types of bank risk. For example, Shanker
(1996) found that the use of swaps, futures, and options reduced interest-rate risk.
Meanwhile, Choi and Elyasiani (1996) not only found that options were positively
related to both interest-rate and currency risk, but also, currency swaps reduced
exchange rate risk. Finally, following the study conducted by Yong el al. (2009),
Hirtle (1996) found that the use of interest-rate derivatives increased the interest-rate
exposure of bank holding companies (BHC).
In a different way, Cyree and Huang (2006) concluded that those who engaged
in the derivatives market were at a higher risk in comparison to those who dealt solely
in other securities and investments. Additionally, the results of Pai and Curcio (2005)
confirmed that derivatives enhanced both the credit risk and liquid risk exposures of
bank holding companies. In another work, Pai et al. (2006) found that while credit
risk exposure was reduced by using interest rate derivatives, it was increased by using
exchange rate currency derivatives. Finally, Shao and Yeager (2007) found that while
the use of credit derivatives as a form of buyer protection reduced total risk, using
derivatives as seller protection increased risk.
8
3. Data and methodology
3.1. Data
Daily capital market data, including stock prices and the market indices for
each country, were obtained from stock exchange websites2.
3.1.2 Sample statistics
The sample is composed of 52 banks spread over five regions. European banks
represent 38.461% of the sample, while Asian banks represent 40.384%. However,
only two banks from Saudi Arabia and two banks from Israel represent the Persian
Gulf region. Furthermore, only one bank, from Chile, represents Latin America.
While six banks represent Africa, five of them are from South Africa. Thus, banks
from emerging countries represent 61.538% of total sample while 38.462% of total
sample characterize banks from recently developed countries. Additionally, the
sample also includes eight dealer banks, which represent 15.384% of the total banks3.
In terms of the research sample, with the exception of Imperial Bank, each
bank made use of forwards. Swaps were the second most used instruments with 49
banks. Moreover, three quarter of banks were involved in using options, while only
44.23% of banks used futures. In general, the two most commonly used instruments
were forwards and swaps, which were utilized by 92.31% of all banks, as shown in
Table 1.
Table 1. Number and percentage of banks per derivative instruments used
Instruments Number of banks PercentageFWD+SWP+OPT+FUT 23 44.23%FWD+SWP+OPT 39 75.00%FWD+SWP+FUT 23 44.23%FWD+OPT+FUT 23 44.23%SWP+OPT+FUT 23 44.23%FWD+SWP 48 92.31%FWD+OPT 39 75.00%
2 www.bolsadesantiago.com, http://zse.hr, www.pse.cz, www.cse.com.cy, www.tse.ee , http://www.hkex.com.hk/eng/index.htm,www.idx.co.id, http://www.tase.co.il , www.klse.com.my, www.stockexchangeofmauritius.com, www.nasdaqomxbaltic.com,www.pse.com.ph, http://www.gpw.pl/root_en, www.tadawul.com.sa, www.sgx.com, http://www.jse.co.za , eng.krx.co.kr,http://www.twse.com.tw/en , www.set.or.th, http://www.ise.org/Home.aspx3 Hellenic Cyprus Bank, Hang Seng Bank, Hapoalim, EON Berhard, BRE Polish, First Rand Bank,ABSA, Industrial Bank of Korea.
The four derivative instruments, forwards, swaps, options, and futures,
represent 190.36% of assets, covering the period from 2003 to 2009, with an average
bank size of approximately $10 billion. During the study period, swaps were the most
represented instruments, with a notional value equal to USD $10,836,706 trillion, or
106.36% of the total assets, while futures represented 6.37% of total assets.
Moreover, in terms of yearly totals, the highest notional value occurred in
2005, when swaps represented 131.00% of assets. In contrast, the lowest percentage
occurred in 2008, when futures comprised only 3.86% of total assets. More details
concerning derivative instruments statistics are summarized in the Table 4.
Stock prices were used to determine the volatility of stock returns. Daily
returns on individual bank stocks i, for each country, were computed using the
following formula:
1,
1,,,
ti
tititi P
PPR . (1)
Market indices were used to calculate the of each bank i following the standard
definition of market risk :
)var(),cov(
,
,,,
tm
tmtiim R
RR . (2)
3.1.1. Sample description
In total, 52 banks, from 12 emerging countries and 9 from recently developed
countries, define the sample for this study. The latest classification by the United
10
Nations Office based on the Human Development Index 4 is used to distinguish
between emerging and recently developed countries. The Table 2 below presents this
classification, while Table 3 includes lists of banks by country.
Table 2. Countries classification
Emerging countries Recently developed countries
Chile; Croatia; Cyprus; Indonesia;
Malaysia; Mauritius; Philippines;
Poland; Saudi Arabia; South
Africa; Thailand; Turkey
Czech Republic; Estonia; Hong
Kong; Israel; Latvia; Lithuania;
Singapore; South Korea; Taiwan
Table 3. Banks and their countries
Countries and bank names Countries and bank namesChile Philippines1.1 Banco de Chile 13.1 Philippine National Bank
Croatia Poland2.1 ERSTE & STEIERMÄRKISCHE BANK D.D 14.1 Bank BPH SA2.2 Privrednabanka Zagreb 14.2 Bank Pekao S.A.2.3 Zagrebacka Banka 14.3 Bank Zachodni WBK
14.4 BRE PolishCyprus 14.5 Kredyt Bank S.A.3.1 Bank of Cyprus Group 14.6 Nordea Bank Polska S.A.3.2 Hellenic Cyprus Bank
Saudi ArabiaCzech Republic 15.1 Arab National Bank4.1 Komerční Banka 15.2 Saudi British Bank
Estonia Singapore5.1 Swedbank Estonia 16.1 DBS Bank
16.2 United Overseas BankHong Kong6.1 BEA South Africa6.2 Chong Hing 17.1 ABSA6.3 DAH SING Bank 17.2 Capitec bank6.4 Fubon Bank 17.3 First Rand Bank6.5 Hang Seng Bank 17.4 Imperial6.6 Wing Hang Bank 17.5 Sasfin
Indonesia South Korea7.1 DANAMON 18.1 Industrial Bank of Korea
18.2 Korea Exchange BankIsrael8.1 FIBI Taiwan
4 http://hdr.undp.org/en/
11
8.2 Hapoalim 19.1 Hua Nan Commercial Bank19.2 Mega International Commercial Bank
Malaysia 19.3 Taiwan Business Bank9.1 CIMB Bank Berhard Malaysia9.2 EON Berhard Thailand
20.1 Bangkok ThailandLatvia 20.2 Bank of Ayudhya10.1 DNB Nord Banka 20.3 Kasikorn
20.4 KTB BankLithuania11.1 ŠIAULIU BANKAS AB Turkey11.2 Swedbank Lithuania 21.1 AKBANK
This paper aims to clarify the effect of derivative instruments on bank capital
market risk. To this end, the main question is as follows: “Do banks increase or
decrease their capital market risk by using derivative instruments?” Therefore, the
major objective of this study is to determine the risk that banks from both emerging as
well as from recently developed countries undertake when using derivatives.
Moreover, this study also analyses the impact of four derivative instruments
(options, swaps, forwards, and futures) on three measures of capital market risk,
which are total return risk, market risk, and unsystematic risk. Enhanced regression
results were found when banks from emerging countries and those from recently
developed countries were regrouped into the same equation regression. Additionally,
a country dummy was introduced in order to identify the specificity of each country.
As a result, this study is the first paper to combine banks from both emerging and
recently developed countries in order to investigate the relationship between
derivative instruments use and bank risk.
After analysis of the using pooled data from 2003 to 2009, as well as a sample
composed of 52 banks from both emerging and recently developed countries,
noteworthy conclusions can be drawn from the empirical results. In general, the use of
options tends to increase all types of bank risk for banks of any kind. In contrast,
swaps, forwards and futures negatively affect capital market risk. Thus, overall, and
as the results show, forwards, swaps and futures may be used effectively as hedging
tools, while options may be viewed in a more speculative fashion.
In sum, the evidence suggests that with exception of options, derivative
instruments do not increase risk. In addition, as the majority of banks generally make
use of forwards and swaps, it seems clear that sample banks are not at risk by using
derivative instruments. Hence, not only should the negative implications attributed to
derivatives in the recent financial crisis be reviewed, but also, more importantly, the
argument that derivative instruments were the principal cause of the most recent
financial crisis should be revised.
19
Acknowledgments
The authors gratefully acknowledge Olfa Benouda Sioud5 for providing the premises
and outlines of the paper.
5 Laboratoire d’Economie et Finance Appliquée (LEFA), IHEC Carthage, Tunisia
20
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