Corporate risk exposures, disclosure, and derivatives use: A longitudinal study

• Author: Gerald D. Gay,Ekaterina E. Emm,Honglin Ren
• DOI: http://doi.org/10.1002/fut.22013
• Published date: 01 July 2019
• Date: 01 July 2019

J Futures Markets. 2019;39:838–864.wileyonlinelibrary.com/journal/fut838

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© 2019 Wiley Periodicals, Inc.

Received: 12 July 2018

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Revised: 2 April 2019

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Accepted: 2 April 2019

DOI: 10.1002/fut.22013

RESEARCH ARTICLE

Corporate risk exposures, disclosure, and derivatives use: A

longitudinal study

Ekaterina E. Emm

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Gerald D. Gay

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Honglin Ren

2

1

Department of Finance, Albers School of

Business and Economics, Seattle

University, Seattle, Washington

2

Department of Finance, Robinson

College of Business, Georgia State

University, Atlanta, Georgia

Correspondence

Gerald D. Gay, Department of Finance,

Robinson College of Business, Georgia

State University, 35 Broad Street, Room

1203, Atlanta, GA 30303.

Email: ggay@gsu.edu

Abstract

We conduct firm and industry‐level examinations of key market risk exposures

deemed material by managers over the period 2002–2016. We find that risk

exposures have expanded in line with firms’growth and globalization and that

managers strategically select disclosure formats in recognition of firms’demand

for capital market access and need to protect proprietary information. Currency

derivatives use has surpassed that of interest rate derivatives and, conditioned

on a firm having the associated risk exposure, commodity derivatives use is the

highest. Finally, we find large increases in risk exposures concurrent with the

initiation of derivatives use.

KEYWORDS

derivatives, disclosure, regulation, risk management

JEL CLASSIFICATION

G18; G23; G32

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INTRODUCTION

In this paper, we seek to complement existing studies of corporate risk management that commonly take a normative approach

to understand why companies manage risk. Rather, we take a positive approach and identify and analyze firms’exposures to

key financial market risks that managers have specifically deemed to be material, the formats and methods selected for

disclosing and managing these risks including the use of derivatives, and how these practices have evolved over time.

To facilitate our analysis, we construct a new and extensive database of corporate risk information that spans the union of

all nonfinancial firms comprising the S&P 1500 Index over the 15‐year period 2002–2016. This information largely emanates

from an important rule‐making (SEC Rule S‐K, Item 305) that requires firms to identify and disclose any material exposures to

interest rate, currency, commodity, and equity price movementsusingamethodselectedfromthreespecifiedformats(i.e.,

sensitivity analysis, tabular, or value at risk [VaR]) that differ in their extent of information revelation.

For each firm we obtain annual 10‐K filings and record information taken from Section 7a “Quantitative and

Qualitative Disclosures about Market Risk.”Specifically, we identify each market risk exposure and the selected

disclosure format(s). For firms selecting the VaR format, we further record the method used to model future values of

the economic variable underlying the exposure (i.e., variance/covariance, historical simulation, or Monte Carlo

simulation), the confidence level, and the time horizon for assessing risk. For each exposure, we also record whether a

related derivatives instrument was used and, when available, the notional amount.

Using this information, we explore the following research questions that are focused on three primary areas of inquiry:

1. What is the extent of key market risk exposures that managers explicitly deem to be materially relevant and are thus

required to disclose? How have these risk exposures changed over time and vary across industries? In addition, what

is the extent of and characteristics of those firms who report no market risk exposures?

2. Given the voluntary choice of alternative disclosure formats, what firm and industry‐level characteristics influence a

firm’s choices of format? For firms selecting the VaR format, which quantitative methods and parameters are used

for modeling risk exposures?

3. To what extent do managers use derivatives to manage each associated market risk exposure and how have these

practices changed through time and compare across industries? Further, do firms follow persistent patterns in their

use of derivatives for hedging market risk exposures and what economic factors are associated with the initiation of

the use of derivatives?

Our main findings to these questions are as follows. Each of the main market risk exposures expanded over the

2002–2016 period as firms have increased in size and complexity and become more global. The predominant exposure is

to interest rates (83% of firms), which is high across all industries ranging from 76% of firms in the retail industry to

100% of agriculture firms. Currency exposure is the second largest exposure (54% of firms) led by the manufacturing

industry, followed by commodity risk (23%) with the largest concentration observed in the mining industry. Further, we

observe a large persistent element at the individual firm level as to their exposures to market risk. Also, interestingly,

we find that nearly one‐tenth of all firms report no risk exposures with these firms largely concentrated in the smallest

size quintile and comprising a significant proportion of both the retail trade and services industries.

Sensitivity analysis is the most frequently selected format for disclosing risk, followed by the tabular and VaR

formats. We perform a multinomial logit regression procedure to better understand those factors affecting a firm’s

decision to select a specific disclosure format versus a paired‐alternative format. We find that the propensity of firms to

select the more information revealing tabular format relates to their interest rate and commodity exposures and,

importantly, their demand for capital market access. The propensity to select the least information revealing VaR

format is positively related to the use of currency or commodity derivatives and to competitiveness factors pertaining to

firms’need to protect proprietary information.

For firms using VaR, the variance/covariance method of forecasting future values is the most often used modeling

method. Its use, however, has declined over time likely owing to shortcomings in its underlying Gaussian distributional

assumptions that became more evident during the financial crisis. The Monte Carlo and historical simulation methods

are used by 25% and 21% of firms, respectively, with the Monte Carlo method showing increase use over time. Further,

the majority of firms use a 95% confidence level and a 1‐day risk horizon.

Regarding derivatives use, more than half of all firms (56%) use derivatives. Interestingly, this overall percentage has

changed little over time, but we do observe trends with respect to specific derivatives types. Notably, interest rate derivatives

use has declined, likely attributed in part to a falling and low interest rate environment. Consistent with increasing levels of

the globalization of firms’business activities, the number of currency derivatives users has trended upward and now exceeds

those using interest rate derivatives. While the number of commodity derivatives users is the lowest unconditionally, it is the

largest in terms of firms indicating commodity exposure at 77%ofsuchfirms.Incomparison,currency and interest rate

derivatives users are at 65% and 37%, respectively, of firms with the corresponding risk exposures.

The magnitude of derivatives use in terms of notional amounts has also grown significantly over time. However, when

analyzed in the context of the magnitude of associated risk exposures, notional amounts have remained at relatively stable

percentage levels. To illustrate, the median amount of interest rate derivatives held by firms grew from $150 million to $428

million from 2002 to 2016. However, when scaled by long‐term debt, the median notional amount has stayed at around 29%,

as exposures similarly grew over time. We alsofindthatnotionalamountsofcurrencyderivatives in relation to foreign sales,

and commodity derivatives amounts in relation to inventory levels have been relatively stable over time at about 14%.

Finally, we test for and find a high degree of persistence in firms’use of derivatives in their management of their

various risk exposures. Importantly, we also find a strong association between large increases in firm’s market risk

exposures and their initiation of the use of derivatives to manage these increased risks. Specifically, we observe that

firms initiating the use of currency and interest rate derivatives have concurrent large increases in foreign sales and the

use of long‐term debt relative to other firms. This finding provides supporting evidence to economic theories that posit

alternative channels through which hedging can increase firm value.

1

This literature argues that by stabilizing cash

flow volatility via hedging, a firm may increase expected cash flows through a reduction in expected financial distress

and business disruption costs, and by helping to ensure the availability of internally generated funds to support strategic

1

See, for example, Aretz and Bartram (2010), Carter, Rogers, Simkins, and Treanor (2017), and Geyer‐Klingeberg, Hang, and Rathgeber (2019) who provide comprehensive surveys of this literature

that presents and tests rationales for corporate hedging; a primary foundation for these studies being the examination of channels through which hedging can enhance firm value, typically based on

violations of assumptions underlying the Modigliani and Miller (1958) framework.

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