Working Paper

Risk Management and Derivatives Losses

Abstract: Even though financial risk management has the ability to generate value, the use of financial derivatives among nonfinancial corporations remains limited. We identify a channel that contributes to this limited use: the decoupling of derivatives losses and operational gains. Specifically, firms ex post consider their operational profits separately from their derivatives profits. We explore this phenomenon among firms in Mexico. We use the universe of US dollar Mexican peso currency derivatives transactions in Mexico along with customs data to construct a unique data set on operational exchange rate exposure and financial hedging. We find that contrary to a rational and frictionless benchmark, performance in previous derivatives transactions predicts future derivatives use. Using a regression kink design to measure the impact of decoupling on risk management, we find that when losses from previous transactions increase 1 percentage point, firms become 4.24 percentage points less likely to take out a new derivatives position within 90 days. We provide further evidence that is consistent with decoupling and supports rejecting a net worth channel.

Keywords: risk management; exchange rates; financial hedging; narrow framing; loss aversion;

JEL Classification: G32; F31;

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Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Working Papers

Publication Date: 2023-07-01

Number: 23-8