Judging the Risk of Financial Instruments: Problems and Potential Remedies

43 Pages Posted: 23 Jun 2004

See all articles by Lisa Koonce

Lisa Koonce

University of Texas

Marlys Gascho Lipe

University of South Carolina - Department of Accounting

Mary Lea McAnally

Texas A&M University - Department of Accounting

Date Written: June 2004

Abstract

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

Koonce, Lisa L. and Lipe, Marlys G. and McAnally, Mary Lea, Judging the Risk of Financial Instruments: Problems and Potential Remedies (June 2004). Available at SSRN: https://ssrn.com/abstract=557863 or http://dx.doi.org/10.2139/ssrn.557863

Lisa L. Koonce

University of Texas ( email )

Dept. of Accounting
McCombs School of Business
Austin, TX 78712
United States
512-471-5576 (Phone)
512-471-3904 (Fax)

Marlys G. Lipe (Contact Author)

University of South Carolina - Department of Accounting ( email )

The Francis M. Hipp Building
1705 College Street
Columbia, SC 29208
United States
803 576-5552 (Phone)

Mary Lea McAnally

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States
979-845-5017 (Phone)
979-845-0014 (Fax)

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