Risk Management and Derivatives Losses 
This paper examines nonfinancial corporate risk management by studying how the outcomes of previous derivatives positions predict future hedging behavior. For their analysis, the authors focus on nonfinancial firms in Mexico. They construct a novel data set that combines the universe of derivatives transactions in Mexico with international trade transactions and foreign currency borrowing.
Key Findings
- The larger a firm’s losses from a derivatives position, the smaller the likelihood of the firm taking a new position. When losses from a previous derivatives position increase 1 percentage point, firms become 4.24 percentage points less likely to take out a new position within 90 days.
- However, when the most recent derivatives position expires and yields gains, the probability of taking a new position is the same regardless of the magnitude of the gains.
Implications
The authors show that the differential responses to gains and losses from derivatives positions are due to a decoupling of financial profits from operational profits. Specifically, firms consider their operational profits ex post separately from their derivatives profits due to either behavioral frictions, specifically the combination of narrow framing and loss aversion, or organizational frictions.
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.