The call options theory of corporate security valuation is applied to the contingent claims of a bank conducting loan portfolio hedging diversification under government capital injection. We find that diversification is not guaranteed to produce efficiency
gain. It is shown that hedging diversification transaction leads to superior equity return performance and greater safety for the bank; however, it results in increasing the efficiency loss from diversification. While we show that government capital injection helps increase bank equity return and decrease equity risk, we document detrimental effects on the efficiency loss from diversification. From a normative standpoint, our results suggest that the bailout program of government capital injection creates an incentive for banks to pursue hedging management strategies.
International Journal of Innovative Computing, Information and Control 11(6), pp.1931-1946