The crash of 2008 and the multibillion-dollar trading loss suffered by JPMorgan Chase early this year have given a bad name to derivatives, the financial instruments that—despite their critical roles in business—had gone largely unrecognized beyond Wall Street and corporate executive suites. That lack of recognition is hardly surprising. Until recently, firms had no obligation to explain their use of derivatives. Even the markets had no idea of why and how firms used the instruments and their impact on firms’ value.

However, a change in financial accounting standards that went into effect in November 2008 required firms to detail all transactions involving derivatives. Hariom Manchiraju, an assistant professor at the Indian School of Business; Spencer Pierce, a graduate student at the Kellogg School of Management; and Swaminathan (Sri) Sridharan, a professor of accounting information and management at the Kellogg School, have analyzed information disclosed under that requirement by American oil and gas companies to determine for the first time the precise role of derivatives in corporate finance.

“Our analysis provides evidence of firms structuring derivative positions to achieve a wide variety of purposes including managing risks, minimizing contracting costs, meeting markets’ and analysts’ expectations, etc.,” they state in their paper.

More than six out of every ten firms the team studied use derivatives for purposes other than managing risks.

A Major Surprise
The analysis has yielded a major surprise. According to the traditional perception, companies rely on derivatives for risk management, because they allow firms to hedge against volatility in cash flow and earnings. But more than six out of every ten firms the team studied actually use the instruments for purposes other than managing risks. “I didn’t expect that,” Sridharan says. The data also reveals that this adventurous strategy does not fool the markets. “Markets value derivatives structured only for exploiting their economic substance and not when used opportunistically,” the researchers state in their paper.

Derivatives are assets whose value depends on or is linked to the value of another asset or a liability. That other item can be a stock, a bond, a mortgage, a future sale or purchase commitment, and so on. The economic significance of derivatives stems from that of the underlying items to which they are linked. But they provide their owners with significant financial flexibility in pursuing their investment strategies, including hedging and speculation.

In the past, derivatives also gave executives a certain level of financial privacy. “Until 2008,” the researchers write, “firms were not required to provide (and they usually did not provide) all the details needed for researchers and investors to make fully informed inferences about both the economic significance of and the manner in which firms structured their derivative positions.”

Game Changer
But then the Financial Accounting Standards Board introduced its Statement of Financial Accounting Standards (SFAS) 161. Titled Disclosures about Derivative Investments and Hedging Activities, it mandates firms to disclose all essential information about their use of derivatives. That changed the game.

“One-sixty-one requires firms to classify all derivatives based on their hedge designation, and to quantify both realized and unrealized gains on such derivatives,” Sridharan explains. “For the very first time, markets had a chance to really learn how a company is using derivatives, the actual value of derivatives, and how they are linked with underlying hedged items. Previously it was impossible to know even the level of effective hedge a company achieved through its derivatives.”

The SFAS 161 disclosures consist of huge amounts of technical data. Making sense of the role of derivatives in firms’ management of risk requires careful sampling followed by sophisticated analysis. For a first cut at the data, Sridharan and his colleagues chose records submitted between 2007 and 2010 by companies in the U.S. oil and gas industry. Why oil and gas? “This is an industry in which firms almost always hedge because the oil and gas prices are highly volatile,” Sridharan explains. “We wanted to look at an industry in which there is a natural and inherent demand for hedging to manage risk.”

To take that look, Sridharan and his colleagues collected and analyzed data submitted by 87 companies. The data quickly showed derivatives’ significance for the firms’ bottom lines—gains from derivatives accounted for over 73 percent of earnings before such derivative gains. That was not the only unexpected conclusion. The companies in the sample did use derivatives effectively to manage financial risks. “But we also find that over 62 percent of our sample has derivatives that were not classified as meeting the requirements for hedge accounting,” Sridharan continues. “That also surprised me.” Moreover, the firms whose derivatives were not structured as hedges produced gains that accounted for 92.7 percent of earnings before such gains were made. Those firms also tolerated much greater earnings volatility.

Meeting Benchmarks
His surprise stems from the fact that non-hedging use of derivatives increases risk rather than reducing it. In other words, Sridharan says, the project shows that “derivatives are both highly effective in managing risks and in contributing to increased risks.”

That observation led the team to a follow-up question: why do firms use derivatives for speculation? To answer that, the group first determined how the financial characteristics of any firm relate to its use of derivatives. “As you would expect,” Sridharan says, “those with high financial contracting costs use hedges to minimize risk while those with low contracting costs use derivatives in a non-hedging way.”

For the latter group of companies, the researchers studied three benchmarks of financial performance: meeting or beating consensus analysts’ earnings forecasts, improving the company’s return on assets on a year-over-year basis, and achieving financial turnaround—that is, going from loss to profit over the course of a year. The result: “We find that firms tend to use non-hedge-designated derivatives to meet or beat each of these three benchmarks,” Sridharan reports. “In other words, firms are prepared to take greater risks in the process of trying to reach those benchmarks.”

The Markets’ Response
That finding sparks yet another question: How do stock markets react to the non-hedging use of derivatives? Careful investigation provided an unambiguous answer. “We find that the market is really smart,” Sridharan explains. “When managers use non-hedge-designated derivatives, the market penalizes them. Markets tend to view prudent management of derivatives positively.”

“Firms that have low liquidity and high levels of debt tend to use derivatives to manage risk carefully. Firms with high liquidity and/or low levels of debt use them for other purposes,” Sridharan says. “For the [oil and gas industry], derivatives play a much more important role than anyone suspected,” he says. “Until now, the literature was mixed even on such a basic question as to whether markets valued firms for their derivative use.”

But he cautions against extrapolating his team’s findings to the role of derivatives beyond the oil and gas industry, and particularly to the banking sector. That is because banking involves a complexity of issues that don’t affect the energy business. Nevertheless, he adds, “We are in the process of expanding this research to a much larger list of firms.”


Related reading on Kellogg Insight

Liquidity Rules: Manage innovation or risk repeating history

Hedging Your Bets Is Still a Gamble: Hedge funds and other alternative assets can underestimate risk, overestimate returns

Volatile Assets: Why we know less about bonds than we thought