Derivatives Disclosures and Stock Price Informativeness

Abstract

AbstractThis study examines the effect of SFAS 161, Disclosures about Derivative Instruments and Hedging Activities, on stock price informativeness. FASB issued SFAS 161, effective in 2008, to provide investors with an enhanced understanding of the objectives and implications of firms’ use of derivatives and hedging activities. Our primary goal is to examine whether SFAS 161 facilitates the dissemination of firm-specific information to the market and thus increases stock price informativeness. Using a U.S. sample covering fiscal-years 2001–2018, this study employs a difference-in-difference research design and identifies the treatment group (derivatives users) by conducting a textual analysis of the firm’s derivatives disclosures in the 10-K reports. The results show that for firms that engage in derivatives activities, stock price informativeness increases after the adoption of SFAS 161. We further find that the positive association between SFAS 161 adoption and stock price informativeness is more pronounced for firms with more readable derivatives disclosures. The results suggest that enhanced readability in derivative disclosures play an important role in reducing the information processing costs for investors.Keywords: SFAS 161Stock price informativenessDerivativesReadability Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1 https://www.bis.org/statistics/about_derivatives_stats.htm?m=26392 The FASB has issued the following statements related to the accounting for derivatives: statements No.52, No.80, No.105, No.107, No.119, No.133, No.138, No.139, No.155, and No.161.3 Under SFAS 133, a derivative may be designated as (i) a fair value hedge, a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment; (ii) a cash flow hedge, a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction; or (iii) a foreign currency hedge, a hedge of the foreign currency exposure of an unrecognized firm commitment (foreign currency fair value hedge), available-for-sale security (foreign currency fair value hedge), a forecasted transaction (foreign currency cash flow hedge), or net investment in a foreign operation.4 Using a method similar to that of Guay (Citation1999) and Donohoe (Citation2015), the keyword search flagged all annual reports and searched for specific terms over the fiscal years 2004-2013: forward contract, option contract, futures contract, rate swap, swap agreement, currency exchange contract, foreign exchange contract, derivative instrument, and hedging instrument.5 In Eq. (2), we also exclude current, lagged, and lead value-weighted weekly industry returns of financial sectors for a robustness check.6 We also use the 5-year period before adoption and the 5-year period after adoption for robustness tests. The results remain the same.7 In robustness tests, we include industry fixed effects, and the results remain similar.8 To account for the tax avoidance incentive for using derivatives (Donohoe, Citation2015), we conduct robustness tests. In the tests, we control for tax-related considerations such as a cash effective tax rate, convertible debt, and preferred stock. Furthermore, to address other general incentives for using derivatives, we also include cash flow volatility, earnings volatility, foreign income or loss, and mergers and acquisitions. We also control for the sensitivity of executive compensation to firm value. The results are the same.9 Please refer to the following website for the details of the procedures: https://sraf.nd.edu/data/stage-one-10-x-parse-data/10 The mean of SYNCH for non-users in the post-adoption period is -0.35-0.080 = -0.43. The mean value of SYNCH for users in the post-adoption period is -0.473 ( = -0.43+0.014-0.057). The improvement value is 0.043, which is 10% of the mean value of SYNCH for non-users in the post-adoption period. [0.043/|-0.43|] = 10%