Given a commercial banking firm facing credit risk we develop a dynamic hedging model where the bank management can use credit derivatives. In a continuous-time framework optimal hedging strategies, deposit and loan decisions and consumption are studied. It is shown that the optimal hedge ratio consists of two elements: a speculative term which is controlled by the risk premium and the bank's risk aversion; and a pure hedge term which depends on the preferences of bank owners. Primarily the purpose of hedging is to stabilize the consumption path through a reduction in the variability of the dynamics of the wealth accumulation. Furthermore, we demonstrate that the asset/liability management is optimal if marginal cost equal marginal revenue for loans and deposits at each instant.
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number
17678.
Find related papers by JEL classification: E0 - Macroeconomics and Monetary Economics - - General E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
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