Do Mandatory Hedge Disclosures Discourage or Encourage Excessive Speculation?

Abstract

In order to shed some light on the desirability of hedge disclosures, I investigate the consequences of hedge disclosures on a firm’s risk management strategy. Several major results emerge from this analysis. First, greater transparency about a firm’s derivative activities is not necessarily a panacea for imprudent risk management strategies. I show that such transparency actually induces the firm to take excessive speculative positions in the derivative market. Second, I show that the firm may choose a prudent risk management strategy in the absence of hedge disclosures. However, the selection of a prudent risk management comes at a cost. The firm’s production policy is distorted in the absence of hedge disclosures.These findings suggest that regulators must carefully investigate the trade‐offs between production distortions and risk management distortions in evaluating the desirability of mandatory hedge disclosures for all firms.