Control variable for “CDS model”

Drawing upon the existing literature in derivatives use, CDS use is modeled as a function of CEOs’ risk-taking incentives generated by stock options compensation (vega) and the following control variables: growth opportunities, financial distress (leverage), firm focus (diversification), managers’ risk aversion, delta, bank size, and other derivatives.

Growth opportunities are considered in previous studies to affect derivatives use (Froot et al., 1993; Supanvanij and Strauss, 2010). A positive association between growth opportunities and derivatives has been proposed in existing literature (Froot et al., 1993; Gay and Nam, 1998). Firms with greater growth opportunities are more likely to derive greater benefits from derivatives use. As this is mainly related to the reduction in underinvestment problems; derivatives use helps ensure that managers have the sufficient internal funds to take advantage of available risky positive NPV projects that they might otherwise forgo (Tufano, 1996; Géczy., et al., 1997; Coles et al., 2006; Supanvanij and Strauss, 2010). Growth opportunities are measured with the book to market ratio (e.g., Gay and Nam, 1998; Graham and Rogers, 2002; Rogers, 2002; Géczy et al., 2007).

According to Smith and Stulz (1985), firms that face higher expected costs of financial distress have larger incentives to use derivatives because derivatives can reduce the present value of bankruptcy and the probability of financial distress. Firms can use derivatives to reduce the variance of a firm's cash flow or earnings which enable a firm to have sufficient cash flow to fulfill its fixed payment obligations and reduce the probability of financial distress (Aretz and Bartram, 2010; Supanvanij and Strauss, 2010). Similarly to previous

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studies, leverage is used as a proxy for financial distress (e.g., Tufano, 1996; Rogers, 2002; Aretz and Bartram, 2010). Leverage is measured with the ratio of total debt to book value of assets (e.g., Coles et al; 2006).

I include diversification as a control variable for firm focus. Earlier empirical studies (e.g., Tufano, 1996; Géczy et al., 2007) suggest a negative relationship between the degree of diversification and derivatives use. Firms can choose to reduce firm risk through changing the level of diversification (Coles et al., 2006; Bartram et al., 2011). For all the banks in the sample, data is collected on the number of geographical segments of the firm at the end of each year to measure the degree of diversification (Géczy et al., 1997; Fung et al., 2012). The primary source of data on the number of segments is Datastream supplemented with the hand-collection of missing items from the annual reports.

In line with empirical literature, data were also collected on CEO’s cash and share compensation and included in the control variables to control for CEO’s risk aversion. Literature predicts that CEO’s fixed salaries and cash bonuses will be positively associated with derivatives use (e.g., Barton, 2001; Adkins et al., 2007). Higher fixed salaries and cash bonuses may increase the likelihood of derivatives; this is because the CEO of the firm is likely to have little diversification in personal wealth (Whidbee and Wohar, 1999; Coles et al., 2006; Adkins et al., 2007).36 Consistent with the existing literature, data is collected on CEO base salary, cash bonuses using banks’ annual reports.

In addition to cash compensation, the literature suggests a positive association between executives’ share compensation and derivatives use. Based on the arguments of Smith and Stulz (1985), when executives hold more shares they are likely to use more derivatives to reduce firm’s risk in order to protect their private wealth in the firm. Stock-based

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Others argue that higher cash compensation will be negatively related to derivatives use for hedging (e,g., Knopf et al., 2002; Ertugrul et al ., 2008; Supanvanij and Strauss, 2010). They believe that higher cash compensation will make it easier for the CEO to build wealth that is not tied to firm value, thus make the CEO’s better diversified.

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compensation increases the risk aversion of non-diversified managers and provides the managers with an incentive to reduce the fluctuations in the firm share price to reduce the risk of their wealth invested in the firm. The value of CEO stock grant is calculated by multiplying the number of the CEO’s stock by the price of the bank stock at the end of the fiscal year (Tufano, 1996; Rajgopal and Shevlin, 2002; Géczy et al., 2007; Kim et al., 2008).

The percentage of CEO shareholdings of all shares outstanding also included controlling for the effect of managerial ownership (Whidbee and Wohar, 1999).

The sensitivity of CEOs’ stock and stock options to stock price (delta) is also included. The effects of delta on firm risk are of some interest, because delta can provide risk preference and risk avoidance incentives (Coles et al., 2006). Higher delta increases the expected payoff to the managers and could induce managers to accept higher risky positive NPV projects because managers share gains with shareholders. Nevertheless, higher delta will expose the undiversified managers to more risk compared with the shareholders when stock prices decrease, which induces managers to adopt more conservative strategies and to choose less risky projects (Guay, 1999b). CEOs’ with large deltas are more sensitive to firm performance which may increase managers’ risk aversion (Knopf, et al., 2002; Rogers, 2002). Core and Guay (2002) find a positive association between delta and derivatives use, executives’ with a higher delta are more likely to use derivatives to hedge firm risk. In line with existing literature, delta is mainly used as a control variable (Coles et al., 2006).

Several of the previous empirical studies of derivative use show a positive relationship between firm size and derivatives use (e.g., Tufano 1996; Allayannis and Ofek, 2000). Large banks are expected to use more derivatives because they are more able to take advantage of economies of scale that generate transactions and information cost advantage (Mian, 1996; Géczy et al., 1997; Haushalter, 2000; Judge, 2006). In this thesis, bank size is measured by natural logarithm of total sales (Supanvanij and Strauss, 2010).

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In this thesis, the use of other derivatives by banks is also considered as a control variable. Empirical studies in credit derivatives indicate that CEOs can use other types of derivatives like interest-rate, foreign exchange, equity, and commodity derivatives to manage firm risk (Minton et al., 2009). Fung et al., (2012) find a positive association between CDS use and the use of other derivatives. The notional amount of other derivatives has been hand-collected from banks’ annual reports.