Lisa Koonce
The University of Texas at Austin
Marlys Lipe
University of Oklahoma
Mary Lea McAnally
Texas A&M University
Abstract: Risk disclosures related to financial instruments vary greatly across firms and across time. We investigate the effects of two risk disclosure choices: the descriptive labels used for the instruments and the balance of the disclosures, i.e., whether potential gains as well as potential losses are disclosed for the instrument. Based on judgment and decision making theory, we predict and find experimentally that a derivative security labeled as a swap is judged as more risky than a similar economic position labeled as either fixed rate debt or as a swap used as a hedge. Unexpectedly, additional disclosures describing the exposures for each instrument did not undo this labeling effect. We also show that investors faced only with information about an instrumentÂ’s potential losses evaluate risk as though potential gains are negligible. When provided with disclosures of potential gains as well as potential losses, risk assessments are predictably related to the patterns of relative gains and losses. These assessments are consistent with the underlying exposures and risk management strategies of the firms. Implications for regulators are discussed.
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