Foreign Exchange Sensitivity-Analysis Disclosures and Market-Based Risk Measures

Abstract

This paper examines foreign exchange (FX) sensitivity-analysis disclosures, which are provided according to one of the three market-risk reporting formats allowed by the Securities and Exchange Commission's Financial Reporting Release No. 48 (FRR No. 48). We select a sample of FX derivatives users from the 1997 Fortune 500 list and collect their market risk disclosures for the three years 1997-1999. We estimate a Probit selection model to distinguish the sensitivity-analysis reporters from the rest of the FX derivatives users, and use the Heckman two-stage procedure to correct for potential sample selectivity bias, as well as the endogeneity of the market risk disclosures. Our evaluation of the sensitivity-analysis disclosures indicates that the flexibility allowed by FRR No. 48 makes it difficult to compare the disclosures across firms. Nonetheless, we find that loss estimates are usually expressed in fair value when firms conduct the sensitivity analysis at the derivatives-level, and in earnings or cash flows when the analysis is done at the entity-level. We find that entity-level earnings sensitivity disclosure exhibits incremental predictive power for the market-based exchange rate exposure and stock return volatility. However, derivatives-level fair value sensitivity disclosure does not have explanatory power for future market-based risk measures. These results are obtained after controlling for traditional risk measures, the lagged market-based risk measures, and other derivatives-related disclosures.

Keywords: Derivative financial instruments, SEC market risk disclosures, sensitivity analysis, foreign exchange risk, exchange rate exposure, stock return volatility

JEL Classification: G13, M41