Hedge disclosures, future prices, and production distortions

In this paper, we identify social benefits to hedge accounting disclosures that have not previously been examined. We show that from the perspective of price efficiency in the futures market the key information that is provided by hedge accounting is information about firms' underlying risk exposures. Without this information, the futures price confounds information regarding firms' hedge-motivated trades with their speculative trades, making the futures price inefficient. Our model shows that an inefficient futures price causes significant externalities by distorting the production choices of an entire industry. In the presence of hedge disclosures, the futures price appropriately informs production decisions in the whole industry. In addition to distortion in production choices, we also investigate the effect of an inefficient futures price on the risk-sharing role of the futures market. We find that lack of appropriate information about hedge disclosures also distorts the risk-sharing role of the futures market, thereby resulting in an increase in risk premium embedded in the futures price. Using numerical calculations, we demonstrate that the magnitude of the distortions in expected industry output can be substantial.