Implementation and Communication of Hedging Activities - Essay Example

The results may be understated due to the minimal disclosures required during the sample period. Future research could revisit these tests for the SFAS 133 time period as a way of evaluating the usefulness of more detailed disclosures. This study adds to the empirical evidence regarding the effects of hedging activity by providing direct evidence of analysts' use of and investors' reactions to earnings surprises following the disclosure of the implementation of hedging activities. Managers can "use financing policies to communicate with external investors" (Palepu et al., 2004). For example, a manager can announce that the company has begun hedging activities to signal that the firm is actively seeking to reduce investors' exposure to transitory shocks that are beyond the manager's control such as interest and foreign currency rate changes.

When such exposures are hedged, earnings become a more transparent measure of the results of operations unaffected by transitory shocks. The development of the derivative securities market in the 1980s and 1990s provided managers with several new hedging tools. Financial statement disclosure of derivative activities, which began in the late 1980s, provided an explicit communication of management's hedging activities. In this study, I examine how market participants changed the way they process earnings information after learning of the implementation of hedging activities.

I present evidence that the magnitude of analysts' forecast errors decreased, and that unexpected earnings were incorporated into subsequent earnings forecasts to a greater extent. Further, I find an increase in the magnitude of the earnings-return relation. This evidence empirically supports the claim that when a company communicates that hedging activities have been started, market participants are better able to forecast earnings and view subsequent earnings announcements as providing greater information about future earnings.

Literature ReviewPrior empirical studies measure various attributes of firms that use derivatives relative to firms that do not (e.g. Allayannis and Weston, 2001; Nguyen and Faff, 2002; Guay, 1999; Visvanathan, 1998; Geczy et al., 1997; Mian, 1996; Nance et al., 1993). Guay (1999) provided evidence of firms' motivations to implement derivative strategies by showing that firm risk declined following the implementation of a derivative strategy.