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FIN62004 Derivatives

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Finance theory suggests that capital market imperfections create incentives for firms (including banks) to use derivatives for hedging purposes. Several authors, such as Smith and 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 and Stulz (1985) and Mayer and Smith (1982) develop financial distress arguments for derivative usage for hedging purposes and claim that 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 and Carter (2000) contend that 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. Required: 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 financial model (e.g. 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 Bloomberg, Bankscope database and information published by (e.g. the Central Bank of Malaysia). Finally, the ECON FREDOM data was obtained from the Bloomberg or Heritage Foundation webpage. 1. Select at least 6 Banks in Malaysia and the selection should be a combination of commercial bank and Islamic bank for the purpose of comparison between 3 commercial banks and 3 Islamic banks that use derivatives (6 in total). 2. Download TOTAL INCOME, TOTAL DEPOSITS, and TOTAL NONINTEREST EXPENSES as well as macroeconomic variables (e.g. GDP, palm oil price, used in the Multiple Regression or OLS regression (LOANS, EQUITY RATIO, and TOTAL ASSETS of the banks data from 2010-2018. Divide the sample into two periods; 2010-2018 (whole period) & 2015-2018 (Chinese stock market turbulence). 3. Analyze the impact of China-US trade war on Malaysia and compare with other Asian countries such as Singapore, Indonesia, Thailand) economic performance. Based on the analysis above, critically analyze the performance of derivatives both commercial banks and Islamic banks and the impact of China-US trade war on Malaysia economic performance.

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