Hedging and hedging effectiveness under required disclosures: a study of the impact of derivatives use on capital investment

Abstract

The purpose of this paper is to study the impact of derivatives use on corporate capital expenditures by utilizing reporting changes under 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 its purpose and its hedging effectiveness. This greater transparency is expected to incentivize firms toward demonstrating greater effectiveness in their derivatives use for hedging purposes. The literature on the real consequences of derivatives use is limited, probably due to the difficulty of ascertaining its hedging effectiveness in addition to its purpose, which is made possible under SFAS 133. Since effective hedging reduces risk exposure, lowers the costs of financial distress, and mitigates underinvestment, it can have a real effect in the form of raising the level of capital investment. The research in this paper distinguishes itself from earlier studies in linking derivatives use to hedging and hedging effectiveness in its study of the impact of derivatives use on capital investment. I find evidence supporting a positive effect of derivatives use on capital investment. Additionally, a lower risk exposure that can be linked to hedging effectiveness, as it is under SFAS 133, is shown to have a positive impact on capital investment. From a policy standpoint, the results suggest that required disclosures may have a real impact if they provide affected firms with an incentive to change their behavior while meeting the disclosure requirements.