The Effect of Footnote Disclosure on the Value Relevance of Banks' Financial Derivatives: The Role of Investor Sophistication.
This paper examines the effect of footnote disclosure and the role of investor sophistication in explaining the value relevance of banks’ financial derivatives. The study focuses on the U.S. bank holding companies and their footnotes for financial derivatives around SFAS 161’s enactment. By regulating footnote disclosure SFAS 161’s aim is to help investors become better informed about the effects of firms’ derivatives activities. Textual analysis on derivative disclosure indicates that both display and contents are changed under the standard. Empirical results show that the change is associated with higher value relevance of banks’ trading derivatives. Using institutional ownership and analyst following to proxy firms’ investor sophistication, the results reveal that, before SFAS 161, the firms with high investor sophistication had greater value weight on trading derivatives than did their low counterparts, but that difference narrowed after Statement 161 became effective. The new requirement not only favors the firms with low sophisticated investors but also benefits the ones with high institutional ownership. These findings confirm the positive impact brought by SFAS 161 and suggest that investor sophistication matters to the value relevance of financial derivatives, while enhanced disclosure can reduce the role of sophistication and level the playing field for market participants.