Judging the risk of financial instruments: Problems and potential remedies
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Information that firms provide about financial instruments and derivatives should help investors judge risk. However, this paper reports that such information often is not effective for this purpose. Through a series of experiments, we demonstrate that the labels firms use to describe financial instruments and derivatives cause investors to assess economically equivalent instruments as different in terms of risk. We also show that loss-only disclosures that companies use to describe their risks cause investors to assess the same level of risk for firms with differing underlying exposures. Moreover, we establish that loss-only disclosures cause investors to make risk judgments that correspond to infrequently used risk-management strategies. We test two possible remedies for these judgment problems. Our results show that additional information describing the underlying economic exposures of a financial instrument does not eliminate the labeling effects. However, we do find that providing investors with upside and downside (i.e., two-sided) risk disclosures help them distinguish among firms using different risk-management strategies.
