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How Do Financial Firms Manage Risk? Unraveling the Interaction of Financial and Operational Hedging

Gatton College of Business and Economics, University of Kentucky, Lexington, Kentucky 40506
kristine.hankins{at}uky.edu

This paper investigates how firms manage risk by examining the relationship between financial and operational hedging using a sample of bank holding companies. Risk management theory holds that capital market imperfections make cash flow volatility costly. I investigate whether financial firms consider this cost or focus exclusively on managing tradable exposures. After documenting that acquisitions provide operational hedging by reducing potentially costly volatility, I find that postacquisition financial hedging declines even after controlling for the specific underlying risks. In addition, the decrease in financial hedging is related to the acquisition's level of operational hedging. Larger increases in operational hedging are followed by larger declines in financial hedging. These results indicate that firms in this sample manage aggregate risk, not just tradable exposures, and that operational hedging can substitute for financial hedging.

Key Words: finance; corporater finance; financial institutions; banks; risk management
History: Received: July 31, 2007; accepted: July 7, 2009.