Effect of Derivative Accounting Rules on Corporate Risk-Management Behavior

Abstract

This paper examines the effect of the accounting standard for derivative instruments (SFAS No. 133) on corporate risk-management behavior. SFAS 133 requires companies to recognize the fair value of derivative instruments in their financial statements; however, it provides preferential accounting treatment for derivative instruments that effectively hedge the underlying business risk. Thus, I hypothesize that the effect of the standard on firms' risk-management activities varies depending on the hedge effectiveness of the derivative instruments. I designate a new derivative user as an effective hedger (EH firm) if its risk exposures decreased relative to the expected level after the initiation of the derivatives program and as an ineffective hedger/speculator (IS firm) otherwise. The empirical results show that risk exposures relate to interest-rate, foreign exchange-rate, and commodity price decrease significantly for IS firms but not for EH firms after the adoption of SFAS 133. Consistent with the decrease in risk exposures, I find that the volatility of cash flows for IS firms also decreases significantly while the volatility of earnings remains unchanged. The combined evidence suggests that SFAS 133 has encouraged firms to engage in more prudent risk-management activities.