Do Sophisticated Investors Use the Information Provided by the Fair Value of Cash Flow Hedges?

Abstract

An unrealized gain on a cash flow hedge implies that the price of the underlying hedged item (i.e., commodity price, foreign currency exchange rate, or interest rate) moved in a direction that will negatively affect the firm’s profits after the hedge expires. Similarly, a loss implies that prices moved in a direction that will positively affect the firm’s profits after the hedge expires. Prior research shows that unrealized gains/losses on cash flow hedges are negatively associated with future earnings, and that investors’ expectations, as reflected in stock prices, do not appear to anticipate this association. We provide further evidence on this identified mispricing by examining whether sophisticated information intermediaries (i.e., financial analysts) understand the future earnings effects of cash flow hedges. We offer three main results. First, we find that analysts do not correctly incorporate unrealized cash flow hedging gains and losses into their earnings forecast for two- and three-year ahead earnings forecasts. Second, we find that analysts correct their errors after the cash flow hedges have largely expired (i.e., in about one year), and that investors correct their mispricing at this time. Finally, we find that when managers provide forecasts, analysts and investors are better able to process cash flow hedge information. Overall, our results suggest that the fair value accounting model for cash flow hedges combined with complex and incomplete firm disclosures results in investor mispricing, even for sophisticated investors, and that this mispricing can be mitigated if managers provide more transparent, complete, and forward-looking disclosures.