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Does Hedging with Derivatives Reduce the Market’s Perception of Credit Risk?

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Does Hedging with Derivatives Reduce the Market’s Perception of Credit Risk?

Federal Reserve Board,

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Firms that use derivatives for speculation face market penalties.

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7

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  • Analytical
  • Innovative
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Warren Buffett has famously characterized derivatives as “financial weapons of mass destruction.” That almost proved to be the case when their use in the run-up to the 2008 financial crisis threatened to bring down the global economy. But derivatives also can mitigate firm risk. Economists Sriya Anbil, Alessio Saretto and Heather Tookes examine whether the market imposes a penalty on companies that don’t use their hedge positions for purely financial management purposes. Although technical, their report contains some good input that getAbstract expects financial managers and investors will find useful.

Summary

Nonfinancial firms use derivatives not only to manage their risk exposures but also for speculative purposes. When hedges help offset an underlying asset risk, they get favorable treatment under US accounting rules, which allow companies to forgo marking those derivatives to market, thus avoiding earnings volatility. To understand whether the market imposes any credit penalty for derivatives’ use in speculation as opposed to hedging, it is important to differentiate between those hedges that receive favorable accounting treatment – that is, the “designated...

About the Authors

Sriya Anbil is an economist with the Board of Governors of the Federal Reserve. Alessio Saretto is an assistant professor of finance at the University of Texas at Dallas. Heather Tookes is a professor of finance at the Yale School of Management.

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