Hedge Effectiveness Under Required Disclosures: A Study of the Impact of Hedging on Capital Investment of Derivatives Users

Abstract

The purpose of this paper is to study the impact of hedging on corporate capital expenditures by utilizing the changes in hedge effectiveness following the disclosure requirements of the Statement of Financial Accounting Standards 133 (SFAS 133). The standard requires firms to recognize and report the use of derivatives in their financial statements, including the purpose of use and the extent of hedge effectiveness. The greater transparency that comes with the standard is expected to incentivize firms toward demonstrating greater effectiveness in their hedging activities. Since effective hedging, by reducing risk exposure, can lower the costs of financial distress, it can raise the level of capital investment. The literature on the real consequences of hedging is limited despite the prevalence of corporate use of derivatives for hedging. The research in this paper contributes to this literature by examining the impact of hedging on capital investment. It also provides evidence on the relation between risk exposure and capital investment when a link can be established between hedge effectiveness and risk exposure, as it is the case under required disclosures.