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E-MailThe following post comes to us from Lin Nan of the Accounting Department at Carnegie Mellon University.
In the forthcoming Journal of Management Accounting Research paper, An Unintended Consequence of SFAS 133: Promoting Speculation, I focus on the agency problem created by the Statement of Financial Accounting Standards No.133 (SFAS 133)and examine how this policy influences firms’ hedging/speculating decisions through agents’ compensation. SFAS 133 allows firms to apply hedge accounting only to qualified hedges that pass effectiveness tests. Unqualified hedges (speculations) are required to be marked to market, and the unrealized gains/losses are to be recognized in earnings immediately. The purpose of SFAS 133 is to improve the timeliness of the information about financial derivatives risk.
Using a specific agency model, I show that the early recognition of the unqualified use of derivatives may change the risk allocation in the manager’s compensation and motivate speculation. Speculation is modeled as engaging in high-risk high-return derivatives contracts, while hedging activities are modeled as engaging in low-risk low return contracts (the low return is normalized to be zero for simplicity). The higher expected return from speculation makes it possible for the principal to offer a lower incentive in the early stage of derivative contracts. The lower incentive, in return, makes speculation less detrimental when the induced volatility is recognized earlier than the maturity date of the contracts, because the induced risk premium is decreased with the lower incentive.
The full paper is available for download here.
