Do Derivatives Disclosures Impede Sound Risk Management?

Abstract

We model an environment in which firms disclose only one side of a hedging transaction, namely the gain or loss on the forward. However, the firm cannot credibly disclose the other side of the hedging transaction, namely the underlying exposure that is being hedged. We show that because the firm cannot credibly communicate that the exposure from its underlying project is hedgeable, greater transparency in the firm's derivative activities distorts firms' hedging decisions.

The nature of these distortions depend crucially on (i) firms' information quality about their project types and (ii) the market's prior beliefs about whether or not firms have hedgeable projects.

For most reasonable levels of information quality, we find that instead of impeding risk management, derivative disclosures are likely to induce firms to engage in excessive speculation.

JEL Classification: M41, M44, M45, G13