Investor Perceptions of Derivatives Hedging: Knowledge, Disclosure, and Asset Manager Assessment

Introduction and Literature Context

The proposed research will explore the perceptions of investors toward the use of derivatives and their assessment of managers who employ derivative strategies. The review of the literature on how investors perceive derivatives provided a broad swath of research and an international perspective. The area of behavioral finance is of particular relevance to the proposed research, as several investigators have suggested. The matter of asymmetrical information—a classic consideration in investment—emerged in a somewhat distinct form in the literature review. The knowledge level that investors have regarding derivatives appeared to play an important part in how managers who use derivatives are perceived, in investors' perceptions of the investment strategy, and in the ability of market participants to generate accurate and complete earnings forecasts. The range of literature reviewed offered insights into many different facets of the role of derivatives and the manner in which participants in the market act on derivatives usage.

A review of the literature revealed that substantive differences exist in the perceptions of investors and asset managers toward derivatives as an investment strategy. The disparate research findings across studies in different countries is a clear indication that research findings must be presented against the backdrop of their dominant sociological and cultural aspects of the research context. As we have seen, French investors do not necessarily respond the same as Chinese investors, and neither appears to exhibit risk behaviors identical to American investors. This clear disparity suggests that the proposed research must do one of two things: (1) systematically conduct research in one or more countries in order to make comparisons, or (2) restrict the research to a particular nation or region. This researcher chooses the latter and will develop a sample frame that draws subjects only from the designated country.

This research is grounded in the positivism philosophy, for which highly structured methodology is employed to enable generalization and quantifiable observations and the evaluation of results with the use of statistical methods (Saunders, 2003). Against the positivism background, this study will employ quantitative methods to collect and analyze data (Saunders, 2003). Accordingly, this author will play the role of an objective analyst in order to evaluate the collected data and produce an appropriate result that achieves the research aims and objectives (Saunders, 2003). The research objective of this study is to specifically examine the perceptions of investors toward use of derivatives and their assessment of managers who employ derivative strategies.

The research takes a deductive approach in which the reasoning progresses from general theories to specific instances. Zheng et al. (2011) studied the attribution of value to the use of derivatives by investors. Their research suggested that gaps in financial knowledge contributed to investors' low value of derivatives and further study could examine the relation between asset managers' explanations about the purpose and value of derivatives hedging to investors and the investors' perceptions about hedging before and after the provision of investment education.

Research conducted by Reynolds-Moehrle (2005) shed light on the effect that managerial disclosure has on investors' reactions to earnings information, using empirical procedures to compare forecast revision behavior, earnings predictability, and earnings response coefficients before and after disclosure of sustained hedging activity. Their findings suggest future research to examine variation in the duration and frequency of disclosures provided during set periods.

The problem under consideration in this study is whether the provision of education to asset managers and investors about derivative hedging will contribute to improved justification and use of the strategy by asset managers, and to increased acceptance of and comfort with the strategy by investors. Accordingly, the following research questions have emerged from a review of the literature:

Research Plan and Philosophical Grounding

Research Question #1: To what extent does the knowledge level of investors influence their perceptions of derivatives as an investment strategy?

Research Question #2: To what extent does the knowledge level of investors influence the perceptions of asset managers' use of derivatives as an investment strategy?

Research Question #3: To what extent does the frequency of managerial disclosure influence the perceptions of investors about the use of derivatives?

Research Question #4: To what extent does the length of time and the frequency of managerial disclosures influence the reactions of investors to earnings surprises?

Of these research questions, two key ideas are salient: How are investors influenced by managerial expertise in derivatives hedging? And how do investors respond to earnings variation when asset managers are highly transparent about their use of derivatives hedging? These questions synthesize important ideas about the dynamics of derivatives hedging and the investor-advisor relationship. The following hypotheses are proposed to focus the research:

H₀: There is no relation between investors' level of knowledge of derivatives hedging and their perceptions of asset managers' strategies.

Research Problem and Questions

H₁: Investors with high levels of knowledge of derivatives hedging perceive their asset managers' strategies more positively than do investors with lower levels of knowledge about derivatives hedging.

H₀: There is no relation between variation in managerial disclosure parameters and the reactions of investors to earnings surprises.

H₁: Increases in the frequency or duration of managerial disclosure parameters are associated with greater levels of acceptance and positive perception of earnings surprises by investors.

In order to gather information about how research participants perceive derivatives hedging, the sample population will be asked to respond to a survey. Both active and non-active users of derivatives will respond to a semi-structured questionnaire. The questionnaire items will be designed to measure the aspects of investing that affect the use of derivatives. The use of semi-structured question items will enable the respondents to provide additional detail or explanation when answering open-ended questions.

A brief pilot of the questionnaire will be conducted by requesting a group of university students majoring in business finance and a group of university students majoring in the arts and humanities to complete the survey. The pilot study will focus on obtaining feedback related to the content validity of the questionnaire. In addition, the pilot test will assess whether the questions are worded in a way that encourages the study participants to be honest and forthcoming in their responses.

The questions will be grouped in the following categories: (1) Perception, (2) Expertise, (3) Value, and (4) Transparency (managerial disclosure). The options that define the level of agreement respondents have with the questionnaire items will be indicated according to a 5-point Likert scale. The scale will use the number "1" to indicate total disagreement with items and the number "5" to indicate total agreement.

Methodology: Data Collection and Design

The independent variables will be: knowledge of the respondent about risk and return and derivatives investing in complex situations; benefits that can result from using derivatives investment strategies; managerial disclosure that exceeds the SFAS 133 hedge accounting requirements; and earnings surprises as measured by perceptions about financial losses that are a result of the inherent nature of derivatives. Perception is the dependent variable that denotes respondents' perceptions of the value of derivatives, their asset managers' derivatives hedging skills, and their receptivity to earnings surprises. These types of perceptions are differentiated accordingly: value perception, hedging perception, and earnings perception.

A multivariate regression model from Bezzina and Grima (2011) will be used to measure the correlation between variables. The regression model will only consider asset managers working in companies that use derivative investment strategies and their investor clients. Perception is the dependent variable Y in function of the independent variables knowledge, perception (of which there are three types), and managerial disclosure. This study uses the model:

y = cX₁ + cX₂ + cX₃ + e

where y is the dependent variable perception, c is the coefficient of X, and e is the error term.

The model is expressed in this way: Y = βX₁ + βX₂ + βX₃ + c + e, where β is the coefficient of X and e is the error term (Bezzina and Grima, 2011). One benefit of using mvreg in Stata 12 software is that you can conduct tests of the coefficients across the different outcome variables. (Please note that many of these tests can be performed after the manova command, although the process can be more difficult because a series of contrasts needs to be created.) The residuals from multivariate regression models are assumed to be multivariate normal. This is analogous to the assumption of normally distributed errors in univariate linear regression. Multivariate regression analysis is not recommended for small samples. The outcome variables should be, at a minimum, moderately correlated for multivariate regression analysis to make sense.