Equity Ratio

Finance theory suggests that capital market imperfections create incentives for firms (including banks) to use derivatives for hedging purposes. Several authors, such as Smith & Stulz (1985), Nance et al. (1993) and Fok et al. (1997) argue that there are three major benefits from using derivatives: reduced taxes under a progressive tax schedule, reduced expected cost of financial distress, and reduced agency cost problems. Smith & Stulz (1985) and Mayer & Smith (1982) develop financial distress arguments for derivative usage for hedging purposes and claim the hedging reduces the volatility of the firm’s value, by reducing the likelihood of costly financial distress and thus increasing the expected value of the firm. The greater the probability of distress or distress-induced costs, the greater the firm’s benefits from hedging through the reduction in these expected cost. Additionally, Sinkey & Carter (2000) contend the larger the debt relative to value, the higher the probability of bankruptcy, and the higher the likelihood that a bank will use derivatives to hedge. Derivatives securities have evolved over the years in response to the needs of individuals and institutions in the increasingly complex and volatile business environment, and have been extremely useful in enhancing the efficiencies of the market. However, largest trading losses involving derivative securities have occurred because individuals who were mandated to be hedgers or arbitrageurs for corporations or financial institutions switched to being speculators. Wrong speculations had led to the collapse of some renowned corporations and financial institutions.

In this assignment you have to measure the effects of derivatives usage on banking efficiency. You are required to examine the financial statements in order to identify banks which contained information regarding derivatives usage. The financial statements containing the data used for the VRS-DEA model (TOTAL INCOME, TOTAL DEPOSITS, and TOTAL NONINTEREST EXPENSES) as well as the variables used in the OLS regression (LOANS, EQUITY RATIO, and TOTAL ASSETS) were obtained from the Bank scope database and information published by (e.g. the Central Bank of Malaysia, Brazil, Chile, and Mexico). Finally, the ECON FREEDOM data was obtained from the Heritage Foundation webpage.
1. Select at least 2 Banks in Malaysia and 2 Banks from other countries for the purpose of comparison between banks that use derivatives and those that do not use derivatives (4 in total).

2. Download TOTAL INCOME, TOTAL DEPOSITS, and TOTAL NONINTEREST EXPENSES as well as the variables used in the OLS regression (LOANS, EQUITY RATIO, and TOTAL ASSETS of the banks data from 2015-2016. Divide the sample into two periods; 2015-2016 (whole period) & 2008-2009 (during crisis).
3. The Mann-Whitney and Kruskal Wallis tests, and a one-way ANOVA were employed to examine the mean efficiency score differences between derivatives user banks and non-user banks.

3. Later the standard deviation and coefficient of variations are calculated to measure the systematic risk exposure
Based on the analysis above, critically analyze whether derivatives user banks are different than non-user banks.

(2500 words) (30 marks)

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