Risk Management In UK Banking - The Role Of Derivatives Hedging In Particular

Thesis (M.A.) from the year 2010 in the subject Economics - Finance, grade: 2,0, University of Portsmouth, language: English, abstract: Risk management has been pivotal banking activity, particularly for the last 20 years. Volatile

economic conditions and ever¿growing competitive forces have compressed profit margins and

forced UK banks to look up to sophisticated and more comprehensive methods of identifying optimal

risk¿return positions. Advanced technology and global business focus has presented opportunities to

utilize comprehensive quantitative techniques to contain and manage risk exposure. Technology has

played crucial role in establishing and dispersing electronic trading platforms giving access to equity

and derivatives hence reshaping capital acquisition and risk management frameworks. The topic of

risk management has been even more contextual in times of severe economic/financial crisis.

Analysts have not only been critical of banks¿ uncollateralized lending but also of their excessive

trading with derivative instruments. Assuming that no arbitrage opportunities exist, the question

remains as to whether banks attempt to hedge their risk exposure or purely speculate on the

direction of price movements. In this context, central task of this dissertation is to examine the role

derivative instruments play in the UK banking system through aggregately assessing risk position of

largest UK banks relative to aggregate trading volumes. Empirical analysis is conducted utilizing a

twöstage SUR technique. Results from first stage of empirical analysis confirm that risk premium on

banks¿ equity securities is strongly related to market risk premium. More importantly, findings

illustrate that exchange rate exposure of UK banks has more significant impact on stock returns

compared to interest rate risk exposure. Second stage of the analysis fails to provide comprehensive

conclusion due and produces controversial results. Nevertheless, exchange rate derivatives are found

to have impact on exchange rate risk albeit only marginally