In this paper we formulate and test a number of hypotheses regarding insurer participation and volume decisions in derivatives markets. Several specific hypotheses are supported by our analysis. We find evidence consistent with the idea that insurers are motivated to use financial derivatives to hedge the costs of financial distress, interest rate, liquidity, and exchange rate risks. We also find some evidence that insurers use these instruments to hedge embedded options and manage their tax bills. We also find evidence of significant economies of scale in the use of derivatives. Interestingly, we often find that the predetermined variables we employ display opposite signs in the participation and volume regressions. We argue that this result is broadly consistent with the hypothesis that there is also a per unit premium associated with hedging and that, conditional on having risk exposures large enough to warrant participation, firms with a larger appetite for risk will be less willing than average to pay this marginal cost.
JEL classification: G2, G3, L2
Key words: financial institutions and services, corporate finance and governance, firm objectives, organization and behavior
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Please address questions regarding content to J. David Cummins, Harry J. Loman Professor of Insurance and Risk Management, University of Pennsylvania, Wharton School, 3641 Locust Walk, Philadelphia, Pennsylvania 19104, 215/898-5644, 215/898-0310 (fax), firstname.lastname@example.org; Richard D. Phillips, Assistant Professor, Georgia State University, College of Business Administration, P.O. Box 4036, Atlanta, Georgia 30302-4036, 404/651-2789, 404/651-4219 (fax), email@example.com; and Stephen D. Smith, H. Talmage Dobbs Jr. Chair of Finance, Georgia State University and Visiting Scholar, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713, 404/498-8873, 404/498-8810 (fax), firstname.lastname@example.org.
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