Bank Interest Rate Risk Management

Empirically, bank equity value is decreasing in the interest rate. Yet (i) many banks do not hedge interest rate risk, and (ii) more than 50% of hedging banks use derivatives to increase exposure. I model a bank’s capital structure and show that these facts are consistent with optimal hedging under financial frictions. Novel predictions on the characteristics of banks taking long or short interest rate derivative positions are tested and supported by the data. Therefore, banks’ derivatives exposures are not necessarily evidence of excessive risk taking. More broadly, the results challenge the view that “hedging” and “speculative” positions can be identified from a positive comovement between derivatives payoffs and equity value.