Hedge accounting and investors’ view of FX risk

Abstract

Purpose This paper aims to examine the foreign exchange (FX) risk effects of cash flow hedge accounting (HA). To the extent the HA qualification criteria and detailed documentation give investors confidence that FX derivatives effectively hedge risk, market-assigned FX risk premiums will be lower for firms using cash flow HA. Design/methodology/approach Probit analyses rely on the HA designation to examine the decision to use cash flow HA. Primary analyses test the hypothesized relationship between the magnitude of FX risk premiums and such HA use. Additional analyses allow for the interaction between cash flow HA use and the extent of FX derivatives use. Findings Hypothesis tests indicate that the magnitude of the FX risk premium is, on average, lower for firms designated as effective cash flow hedgers. In additional tests, the evidence suggests that the market assigns a lower FX risk premium to firms using a higher level of FX derivatives as effective cash flow hedges. Practical implications The findings suggest that cash flow HA provides risk-relevant information to investors. Such positive effects of HA on investors’ understanding of risk management may guide US accounting regulators in their efforts to improve HA. Corporate treasurers also may benefit from these insights into evaluating the use of HA. Originality/value Responding to the call for research on the risk relevance of cash flow HA, this paper merges the HA literature with the FX risk management literature to directly examine the relationship between HA use and FX risk premiums for manufacturing firms. The authors take an innovative approach using FX rates to which each firm is most exposed and provide evidence consistent with the argument that this approach is helpful in understanding both the decision to use cash flow HA and the effect of such HA use on market-assigned FX risk premiums.