Asymmetric effects of fair value adjustments on dividend policy

Abstract

We examine the effect of unrealized fair value adjustments resulting from derivatives classified as cash flow hedges on the dividend policy of UK firms. We theorise and empirically demonstrate that companies differentiate between positive and negative fair value adjustments. When unrealised gains are recorded under ‘Other comprehensive income’ firms do not increase dividend payouts; as such it can be argued that legal requirements surpass potential signaling considerations. However, for unrealized losses, firms reduce their dividend payouts, even when regulatory arrangements do not necessarily mandate this. Furthermore, firms adjust their dividends based on unrealized losses under different levels of firm risk, future growth opportunities and financial distress. Overall, our findings suggest that managers display a conservative behavior aiming to safeguard company assets, by effectively treating unrealized gains as ‘transitory’ and unrealised losses as ‘persistent’.