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Abstract
Regulators are concerned that firms using derivative contracts may engage in imprudent risk management activities. To deter such imprudent risk management activities, the Financial Accounting Standards Board (FASB) has mandated hedge disclosures that require firms to disclose all gains and losses from their derivative activities. Firms contend that these mandated disclosures may actually discourage prudent risk management strategies. To investigate these diametrically opposed claims, this dissertation examines an economic model constructed specifically to analyze the consequences of these mandatory hedge disclosures on a firm's risk management strategy.
This paper establishes a baseline for prudent risk management using a well-defined benchmark regime. Subsequently, the following regimes are compared against the benchmark regime: a regime with mandatory hedge disclosures and a regime without mandatory hedge disclosures. Several major results emerge from this analysis. First, contrary to the FASB's intended effect, mandatory hedge disclosures actually induce the firm to deviate from a policy of prudent risk management. In fact, the firm takes excessive speculative positions in the derivative market. These excessive speculative positions arise naturally whenever the firm is endowed with superior information about its commodity market and is concerned about its market value. Consequently, prudent risk management is never optimal when hedge disclosures are mandated. Second, in the regime without mandatory hedge disclosures, a policy of prudent risk management is optimal.
These two results indicate that mandatory hedge disclosures actually undermine the FASB's main objective, which is to discourage imprudent risk management activities. On the contrary, mandatory hedge disclosures have the opposite effect. Not only do they discourage a prudent risk management strategy, but to make matters even worse, mandatory hedge disclosures actually encourage excessive speculation.
