Hedge Disclosures, Future Prices, and Production Distortions

In this paper, we identify social benefits to hedge accounting disclosures that have not previously been examined. We show that from the perspective of price efficiency in the futures market the key information that is provided by hedge accounting is information about firms' underlying risk exposures. Without this information, the futures price confounds information regarding firms' hedge-motivated trades with their speculative trades, making the futures price inefficient. Our model shows that an inefficient futures price causes significant externalities by distorting the production choices of an entire industry. In the presence of hedge disclosures, the futures price appropriately informs production decisions in the whole industry. In addition to distortion in production choices, we also investigate the effect of an inefficient futures price on the risk-sharing role of the futures market. We find that Arijit Mukherji passed away in October 2000. He was our colleague, mentor, advisor, and friend. We dedicate this paper to his memory and his contributions to the field of accounting. He will be missed. *University of Minnesota; tUniversity of Minnesota and Federal Reserve Bank of Minneapolis; +University of Chicago. We thank workshop participants at the 1998 Accounting Mini Conference at Minnesota, the 2000 Journal of Accounting Research Conference, Berkeley, Columbia, Chicago, the LSE Financial Markets Group, Northwestern, Ohio State, Penn State, Stanford, UCLA, and the European and American Accounting Association Annual Meetings. In particular, we have benefited from the comments of Regina Anctil, Stan Baiman, Mary Barth, Margaret Bray, Robert Bushman, Ron Dye, Frank Gigler, Dan Gode, Charles Goodhart, Rachel Hayes, Thomas Hemmer, Jack Hughes, Jim Jordan, Bjorn Jorgensen, Young Kwon, Richard Leftwich, Nobu Kiyotaki, Rick Lambert, Maureen McNichols, Nahum Melumad, John O'Brien, Jim Patell, Jim Peck, Madhav Rajan, Abbie Smith, Phil Stocken, Brett Trueman, Igor Vaysman, Robert Verrecchia, Amir Ziv, and an anonymous referee. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.