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Does Hedging with Derivatives Reduce the Market’s Perception of Credit Risk?
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Does Hedging with Derivatives Reduce the Market’s Perception of Credit Risk?

Sriya Anbil, Alessio Saretto and Heather Tookes
Federal Reserve Board, 2016
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Editorial Rating

7

Qualities

  • Analytical
  • Innovative
  • Well Structured

Recommendation

Warren Buffett has famously characterized derivatives as “financial weapons of mass destruction.” That almost proved to be the case when their use in the run-up to the 2008 financial crisis threatened to bring down the global economy. But derivatives also can mitigate firm risk. Economists Sriya Anbil, Alessio Saretto and Heather Tookes examine whether the market imposes a penalty on companies that don’t use their hedge positions for purely financial management purposes. Although technical, their report contains some good input that getAbstract expects financial managers and investors will find useful.

Take-Aways

  • Nonfinancial firms use derivatives not only to manage their risk exposures but also for speculative purposes.
  • Derivatives that offset an underlying asset risk get favorable treatment as “designated hedges” under US accounting rules, while those for speculative purposes don’t.
  • Firms with designated hedges enjoy spreads that are 6.8 basis points lower than those of companies that don’t use derivatives. Businesses with “nondesignated hedges” see spreads that are 10 basis points higher than those of firms not using derivatives.

About the Authors

Sriya Anbil is an economist with the Board of Governors of the Federal Reserve. Alessio Saretto is an assistant professor of finance at the University of Texas at Dallas. Heather Tookes is a professor of finance at the Yale School of Management.

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