Risk management with derivatives : interest rate and foreign exchange rate.

Abstract

This thesis examines if a company risk management policy to hedge interest rate risk and foreign exchange rate risk affects the volatility of the stock and the default risk of the corporation. This paper would focus predominantly on the usage and effectiveness of financial derivatives in a firm’s risk management practices to reduce interest rate risk and foreign exchange rate risk.

Next, we also attempt to profile the type of firms that are inclined to use financial derivatives to hedge their interest rate risk and foreign exchange rate risk as opposed to the use of non-derivatives hedging techniques.

The investigation was conducted on stocks traded on S&P1500 using datasets in 2008 (accounting data etc.) and 2009 (observed volatility etc.).

Based on our regression results, we find that the use of financial derivatives reduces both the volatility and default risk (measured by KMV model) of the stock; after controlling several accounting measures variables. We are also able to obtain a reasonable profile of firms that are more attuned to the use of financial derivatives to hedge their risk in interest rates and foreign exchange.