Judging the Risk of Financial Instruments: Problems and Potential Remedies
43 Pages Posted: 23 Jun 2004
Date Written: June 2004
Although information that firms provide about financial instruments and derivatives should help investors judge risk, such information often is not effective for this purpose. We experimentally demonstrate that the labels firms use to describe financial instruments and derivatives cause investors to judge risk based on thoughts associated with the labels rather than the underlying economic exposures of those instruments. We also show that loss-only disclosures currently used to describe the market risks facing companies force investors to make assumptions or inferences to judge risk. These inferences are systematic and often incorrect. We test two possible disclosures that might remedy these problems. Our results show that labeling effects are not eliminated by additional disclosures explicating the underlying economic exposures, but that providing investors with upside and downside market-risk disclosures help them distinguish among firms using different risk management strategies. Implications for managers and regulators are provided.
Keywords: Financial instruments and derivatives, risk judgments, investor behavior
JEL Classification: M41, M43, M44, G13
Suggested Citation: Suggested Citation