The Joint Effect of Presentation Format and Disclosure Balance on Investors’ Reactions to Sensitivity Disclosures of Hedging Instruments

Abstract

Derivative-related risk disclosure has been a key issue in accounting regulation and research, and sensitivity analysis is the most popular form of quantitative derivative-related disclosure. In an experiment, we find that, relative to disclosing potential losses only, disclosing both potential gains and potential losses associated with hedged items and derivatives leads to favorable investor reactions when information about net risk after hedging is omitted from the disclosure, but not when net risk is shown. We further show that disclosing net risk on top of hedged-item and derivative risks is a disclosure remedy that is as effective as disclosing potential gains. Finally, we demonstrate that disclosing net risk and disclosing potential gains operate through different mechanisms. We extend Koonce, Lipe, and McAnally (2005) by showing the generalizability of their findings and proposing an alternative disclosure remedy. Our results have important implications for investors, managers, and regulators.

Keywords: risk disclosure; sensitivity analysis; derivatives; hedge