Author(s): Ruwan Adikaram, David Caban
Motivated by the financial crisis which was exacerbated by the use of derivatives and the worlds current struggles with the novel coronavirus pandemic, this paper examines how the use of derivatives affects a firm’s share price. This study focuses on the banking industry, one of the major users of derivatives. Taking advantage of increased accounting disclosures on derivatives introduced by SFAS 133 and subsequently enhanced by SFAS 161, notional amounts of hedging derivatives and non-hedging derivatives are obtained from 10K and 10Q reports. Borrowing from Barth, a model consistent with the Ohlson (1995) model is used where share prices are regressed on book value per share and earning per share. Consistent with efficient market pricing, which implies that risk cannot be reduced without sacrificing returns if the asset is efficiently priced, the study finds that derivatives used for hedging purposes are negatively associated with firm valuation. This implies that while these derivatives may serve their purpose as risk reducers, they do so by limiting potential future cash flows, hence the negative relationship. On the other hand, non-hedging derivatives actually introduce risk, but they also introduce a valuable revenue stream in the form of trading revenue. Results show that the positive relationship found between the notional amounts of non-hedging derivatives and firm valuation is driven by their revenue generating attribute. Once this element is controlled for, the relationship becomes negative.