The Effect of Derivatives Usage on Risk

The use of derivative financial instruments has become common among large non-financial firms. Theoretical arguments suggest that firms benefit from the use of foreign exchange derivatives to reduce foreign currency risk exposures, and interest rate derivatives to reduce interest rate risk exposures. However, previously no study empirically tests whether the use of derivatives instruments alters risk exposure. This study tests the relevance of derivatives disclosures and the efficacy of firms use of derivatives to manage risk. We examine the association between (i) levels of derivative usage and risk (quot;levels analysisquot;), and (ii) changes in derivatives usage and changes in risk (quot;changes analysisquot;), while controlling for other factors associated with risk. Derivatives usage is measured by the ratio of notional amount of financial derivatives to the market value of the firm. Foreign exchange and interest rate derivatives activity are examined separately and jointly. Risk is measured by variance of return. The levels analysis finds that levels of foreign exchange derivatives are positively associated with risk, suggesting that higher risk multinational firms use more foreign exchange derivatives. The changes analysis reveals a significant association between increases in usage of foreign exchange derivatives and decreases of risk. This is consistent with non-financial firms effectively using foreign exchange derivatives to reduce foreign exchange risk exposures. No significant association is found between interest rate derivatives usage and risk in either the levels or changes analysis. This is consistent with firms using interest rate derivatives for reasons other than reducing risk exposures, such as efficiently altering capital structures. These tests provide the initial empirical evidence on the effects of changes in derivatives usage on risk and support for the relevance of derivatives disclosures