In 2020, U.S. non-financial firms held $31.4 trillion (as measured by notional value) interest rate- and foreign exchange rate-related derivatives (Bank for International Settlements 2020). These observations contrast the hedging irrelevance argument in the frictionless regime of Modigliani and Miller (1958).
No prior research has examined whether and, if so, how corporate derivatives usage affects the likelihood of a stock price crash. This is surprising because information opacity is a central issue underlying the debate about corporate derivative usage and is a key driver for stock price crash occurrences (Jin and Myers 2006, Hong, Kim and Welker 2017). In this study, we aim to fill this gap by providing the first large-sample, systematic evidence on the effect of derivative usage on stock price crash risk.
We test two competing hypotheses. Under the transparency hypothesis, derivatives usage reduces information opacity and lowers crash risk. Under the speculation hypothesis, derivatives usage exacerbates managerial short-termism and increases crash risk. We find evidence supporting the transparency hypothesis. This result is robust to sensitivity checks including a two-stage treatment model, difference-in-differences test, and subsample analysis. We further show that curbing bad news hoarding, curtailing overinvestment, and increasing breadth of ownership are potential channels through which derivatives usage mitigates crash risk. Additional tests on the effect of derivatives usage on likelihood of securities class-action litigation provide consistent results.
Jeong-Bon Kim, Yi Si, Chongwu Xia, Lei Zhang
Paper forthcoming at the European Accounting Review