Market Risk Disclosure as Signal of Risk Management Effectiveness

• In Event: Disclosure and Managerial Ability

Abstract

We hypothesize that market risk disclosure mandated by the U.S. Securities and Exchange Commission Financial Reporting Release No. 48 (FRR No. 48) provides useful signals for predicting risk management effectiveness. Measuring risk disclosure quality as the degree of quantification and modification, we find that higher-than-expected disclosure quality is associated with lower future cash flow volatility. On average, an increase in risk disclosure quality from the lowest to the highest decile is associated with a 4-5% decrease in cash flow volatility. Additionally, firms seem willing to accept increased earnings volatility to attain lower levels of cash flow volatility, suggesting that they make economically rational decisions related to risk management. We also find evidence that the predictive power of market risk disclosure quality with respect to cash flow volatility weakened for financial industries during the financial crisis.

Authors

• Gerald Lobo, University of Houston-Houston

• Wei Z. Siqueira, State University of New York at Albany

• Kinsun Tam, State University of New York at Albany

• Jian Zhou, University of Hawaii-Manoa