The Association between SFAS No. 119 Derivatives Disclosures and the Foreign Exchange Risk Exposure of Manufacturing Firms

Abstract

This study investigates whether the quantitative disclosures about notional amount and fair value of foreign exchange derivatives, required by Statement of Financial Accounting Standards (SFAS) No. 119 and its predecessors are associated with the information used by investors to assess the sensitivity of equity returns to currency fluctuations (currency exposure). I derive the underlying relations of currency risk exposure to notional amount and to fair value disclosures, applying the "delta" risk measure for derivative securities. The analysis shows that derivatives disclosures are potentially useful. I test the hypotheses using the Fortune 500 manufacturing firms over the period 1994-1996. First, I test for an association between currency exposure and derivatives disclosures. Second, I test whether current period derivatives disclosures help predict currency exposures in future periods. The results are mixed and only weakly consistent with my predictions. In particular, the evidence suggests that neither aggregated nor disaggregated fair value disclosures complement notional amount in assessing currency risk exposure.

This study has three implications for increasing the usefulness of derivatives disclosures. First, improving disclosures about firms' inherent business risks will increase the usefulness of derivatives disclosures by providing information about the risks being managed with derivatives. Second, disaggregation of notional amount and fair value information by long and short positions taken, major currency, class of instrument, time to maturity, and leverage would allow users of financial statements to perform a complete exposure assessment. Third, separate disclosure of foreign exchange gains and losses on derivative instruments and the items being hedged will facilitate exposure assessment.

Keywords: SFAS No. 119, Accounting Disclosures, Notional Amount, Fair Value, Foreign Exchange Risk Exposure, Foreign Exchange Derivatives

JEL Classification: M41, M45, F23, G12