Derivative Gains/Losses: Quantity Risk, Corporate Hedge Effectiveness and Earnings

ABSTRACT This study examined how firms should hedge. It is easier for firms to hedge with the right derivative instruments than to prospectively project and hedge the right quantity of exposures. When actual quantity unfolds, project‐actual quantity deviation (quantity risk) leads to hedge ineffectiveness. This could be a sensible explanation for the mixed empirical evidence on whether derivatives use can contribute to firm market value. Hence, this study proposed an under‐hedge hypothesis, which suggests that firms manage quantity risk when hedging. This study employed derivative gains/losses as a proxy to derivatives use, hedged exposure magnitude and hedging instrument performance. The proxy also provides insight into hedge effectiveness when linked to hedged‐risk losses/gains. It found that transaction exposures positively affect derivatives use, and such use contributes to earnings. Consistent with its hypothesis, risk‐averse managers under‐hedge their projected exposures. The planned under‐hedge position allows firms to hedge a substantial portion of their transaction exposures while reducing potential derivative losses if an actual over‐hedge position arises. When actual quantities unfold, this under‐hedge position also provides operational flexibility for firms. This allows them to add extra derivative contracts to hedge the unhedged exposures rather than terminate existing derivative contracts to rectify over‐hedge positions.