Income Statement Effects of Derivative Fair Value Accounting: Evidence from Bank Holding Companies

SFAS 133 requires most types of hedge ineffectiveness to be measured on a fair value basis and reported in earnings. This earnings recognition requirement was the focal point of controversy surrounding the adoption of SFAS 133. The debate also reflects the more general controversy over whether to recognize fair-value-based gains or losses into earnings. Using a sample of bank holding companies, I find evidence inconsistent with the widely held notion that the fair-value-based hedging performance measure represents a form of transitory income. I find that the earnings measure in the post-SFAS 133 period that includes the fair-value-based hedging performance measure outperforms a constructed income measure that excludes this component in terms of ability to explain concurrent stock returns. Additionally, I find that the fair-value-based hedging performance measure has incremental explanatory power over stock returns with hedging losses being given a higher weight than hedging gains. Finally, I document a positive association between the volatility of the fair-value-based hedging performance measure and idiosyncratic stock return volatility. Taken together, the results from this study suggest that the recognition of the fair-value-based hedging performance measure under SFAS 133 improves the value and risk relevance of accounting earnings. These findings are relevant to the evaluation of SFAS 133 as well as the ongoing debate on the income statement treatment of net asset changes due to the application of fair value accounting.