Mary Lea McAnally

Judging the Risk of Financial Instruments: Problems and Potential Remedies

Although information that firms provide about financial instruments and derivatives should help investors judge risk, such information often is not effective for this purpose. We experimentally demonstrate that the labels firms use to describe financial instruments and derivatives cause investors to judge risk based on thoughts associated with the labels rather than the underlying economic exposures of those instruments. We also show that loss-only disclosures currently used to describe the market risks facing companies force investors to make assumptions or inferences to judge risk. These inferences are systematic and often incorrect. We test two possible disclosures that might remedy these problems. Our results show that labeling effects are not eliminated by additional disclosures explicating the underlying economic exposures, but that providing investors with upside and downside market-risk disclosures help them distinguish among firms using different risk management strategies. Implications for managers and regulators are provided.

Banks, Risk and FAS 105 Disclosures

This study examines whether Statement of Financial Accounting Standard No. 105 (FAS105) footnote disclosures of off-balance-sheet financial instruments and derivatives provide risk-relevant information in addition to that provided by the balance sheet alone. A theoretical model relates market and industry risk measures to FAS105 disclosures. Empirical tests of the model reveal that these disclosures do provide risk-relevant numbers although the results are not uniformly strong. The balance sheet financial instruments explain 42 percent of the variation in market risk and 45 percent of the variation in industry-level risk among 499 U.S. commercial bank holding companies. FAS105 disclosures of off-balance-sheet instruments and derivative positions explain an additional 5 to 7 percent of the variation. Stronger evidence is presented that shows that certain controversial classes of derivatives are not associated with increased levels of market and industry-level risk. This latter evidence stands in contrast to the current notion that derivative contracts, especially interest rate and currency swaps, increase overall bank riskiness. Results also corroborate the FASB categorization of classes of financial instruments along two important risk dimensions: credit risk and market risk.

Behavioral Implications of the SEC Market Risk Disclosures

In this paper, we draw on judgment and decision making research to examine the behavioral implications of the SECs Financial Reporting Release No. 48 on derivative and market risk disclosures. While these disclosures have been examined from an empirical point of view, no research has investigated how these disclosures might affect the users. The purpose of our paper is to identify and analyze the behavioral implications of the new risk disclosures. We draw on research done in the judgment and decision making arena to analyze the likely behavioral consequences of these disclosures. Our paper identifies a number of areas for future research on the important topic of market risk.

Investor Reactions to Derivative Use: Experimental Evidence

How do investors evaluate managers who choose to use or not use derivatives once the outcomes of those decisions become known? Competing theories make different predictions, and we test these in three experiments. Results show that even when outcomes are held constant, investors are more satisfied and assign a higher value to a company that uses derivatives than to one that does not use derivatives. This finding is consistent with decision justification theory. Additional tests reveal that this result occurs because investors believe that firm managers who use derivatives to address risk exposures exhibit a higher level of decision-making care. In contrast, we find that speculative use of derivatives is not assumed to result from careful thought, resulting in harsher judgments about management. Overall, our study adds to our understanding of how investors judge companies who use derivatives, given the outcomes that result from such use.