Derivatives and firm risk

Abstract

In October 2001, Enron Gas Service, one of the largest US Corporations failed because of huge loss of 1.2 billion dollars in derivatives transactions and window dressing of debt amounting to 1 billion dollars. Considering that derivatives have been devised to partly resolve market imperfection and thus to decrease risk contained in financial transactions, Enron``s failure coupled with the prevalence of derivatives usage by firms has raised concerns that derivative activities increase the risk of the firm rather than decrease it. This study investigates the empirical relationship between a bank``s derivatives disclosure under the Korean GAAP and firm risk. In doing so, we employ two alternative measures to proxy for firm risk; systematic risk and ex ante earnings volatility (i.e. dispersion in analysts`` forecast errors). Contrary to the general concerns of the bank``s risk-increasing derivative products, the results indicate that banks`` derivatives are, on average, associated with two measures of risk in negative ways. The evidence is consistent with the conjectures that derivatives reduces noise related to exogenous factors and hence decreases the level of firm risk (e.g., Riffe, 1996; McAnally, 1996, DaDalt, Gay and Nam, 2001).