This paper examines whether use of derivative financial instruments affects the security prices of firms which use them. One hundred sixty-three companies across seven industries were studied. Each company traded for three years prior to using any derivatives and continued to be listed and use derivatives for three years afterward. Not all of the industries included in the sample resulted in a significant information content of earnings effect. However, utilities, manufacturing, and finance/insurance did yield statistically significant results. Overall, the evidence suggests that in general investors perceive a difference in the information content of earnings when a firm uses derivatives, and that difference translates into a positive, significant impact on security prices. This is potentially important to the managers of these firms, along with financial analysts and investors.
The use of derivative financial instruments is a contentious issue. Nevertheless, whether one subscribes to Warren Buffet's warning about the danger of derivatives or Allen Greenspan's assertion that derivatives reduce risk (Berry 2003), the fact is that derivatives are popular and growing in use (Bodner, Hayt, Marston, & Smithson 1995). Therefore, given the place of derivatives in the financial market place, it seems reasonable to ask what, if any, information content they provide.
Many studies have examined the risk associated with derivative usage (Cornfield 1996, Guay 1999, Kuprianov 1995, Newman 1994). In general these studies note that firms use derivatives as a hedge against exposure, but find that compared to firms which do not use derivatives, there does not appear to be any measurable difference in risk (Hentschel & Kothari 2001). This would lead one to suspect that no market impact from the use of derivative instruments would be found.
In addition to risk, other researchers have examined the role of derivatives in an earnings management context. Jan Barton (2001,) examined this issue and presented evidence "consistent with managers using derivatives and discretionary accruals as partial substitutes for smoothing earnings." An implication of this finding is that derivatives in fact should have a market impact through their effect on corporate earnings.
An issue for further research deals with the wide variety of derivative structures in use today. For example, weather derivatives have been developed in response to the fact that utility companies find that power demand varies depending on the weather conditions. Similarly, credit derivatives have found a home with some bankers and manufactures (e.g. Siemens). Ultimately, derivative usage depends on the variety of product characteristics available and the industry risk profile to be addressed (Foote 2003). Based on industry need and product availability, we could reasonably expect to find some impact on the information content of earnings within particular industries. However, we also would expect that this effect to vary between industries, as well.
Given the use, nature, and debates about derivative financial instruments, and based on the research undertaken to date, studies, examining the impact of derivatives on securities prices, their purported risky nature, and the variety of derivative financial instrument available in the market place, are important to our understanding, analyses, and use of financial statement data.
As previously noted, recent studies of derivatives do not directly link derivative usage to information content of earnings and security returns. However, if a correlation is established, evidence may suggest that firms could directly or indirectly affect the price of their stock in the capital markets through the use of derivatives.
As a test, earnings are analyzed for incremental information content relative to security prices for firms during periods when derivatives are used versus periods when these same firms did not utilize derivatives. …