5. CONCLUSION
To our knowledge, empirical evidence on the relationship between the use of stock options and CDS for hedging purposes in the banking industry is non-existent. Focusing on banks is imperative given the fact that banks are recognised as a major participant in the credit derivatives market that is dominated by CDS. Knowing that risk appetites at banks can be incentivized through the use of stock options, this poses the question of whether such a commonly implemented pay practice disincentivizes the use of CDS for risk management in banks.
In this study, data of CEO stock options and the notional amount of CDS held for hedging by European banks during the period 2006-2011 were examined. We find that CEO vega is negatively related to the proportion of CDS held by banks for hedging. Robustness checks show that such a negative relationship does not hold when CDS are held for trading purposes. The results, taken together, suggest the role of stock options’ vega as a disincentive for hedging positions, and an incentive for trading positions in CDS contracts.
In further analysis, we find that the extent of CDS held by banks is related to default risk during the period leading up to the financial crisis that erupted in 2007. In times of systemic credit crisis, a bank’s default risk increases even with hedging positions in CDS. During such a period, default protection promised by swap contracts may no longer be available when insurers (sellers) themselves fail in their obligation to protect. In this case, hedging positions are no longer protected from the default risk of their risky assets, and become exposed to a portfolio of credit risk that is greater than they had anticipated. This means that the systemic condition can only increase the default risk for both buyers and sellers of CDS.
