The Joint Effect of Presentation Format and Disclosure Balance on Investors’ Reactions to Sensitivity Disclosures of Hedging Instruments

Abstract

Derivative-related risk disclosure has been a key issue in accounting regulation and research, and sensitivity analysis is the most popular form of quantitative derivative-related disclosure. In an experiment, we find that, relative to disclosing potential losses only, disclosing both potential gains and potential losses associated with hedged items and derivatives leads to favorable investor reactions when information about net risk after hedging is omitted from the disclosure, but not when net risk is shown. We further show that disclosing net risk in addition to hedged-item and derivative risks is as effective at lowering investors’ risk perceptions as disclosing potential gains. Finally, we demonstrate that disclosing net risk and disclosing potential gains affect investors’ judgments through different mechanisms. Our results have important implications for investors, managers, and regulators.