The Effect Of Derivative Financial Instruments On Bank Risks, Relevance And Faithful Representation: Evidence From Banks In Hungary

In a continuously changing business environment accounting data have to provide useful information in order to achieve relevant and faithful representation in financial statements. Since global markets have changed radically, growing international trade means the horizons of investors and borrowers have now become global, which has increased the level of their risks. Concerning international trade and investment, one of the most important risks is uncertainty about future foreign currency exchange rates and interest rates. Changes in financial markets have increased the use of derivative instruments (such as forwards, futures, swaps, and options) to hedge risk exposure worldwide, while the related accounting standards have not kept pace with those changes. Because of the complexity and variety of these instruments, reporting on derivatives faces many difficulties, since a different framework and different accounting concepts are required to present useful financial information. For these reasons the growing use of derivative financial instruments and the challenges of the global financial system have intensified and sharpened debates about whether derivative instruments increase or decrease the risk of banks, affecting faithful representation based on their financial statements and decision usefulness of the reported information. This study aims to describe the transformation of accounting concepts and its effect on fair value accounting for derivative financial instruments in the information economy. The research question of the paper is whether the advantages of fair value accounting exceed the disadvantages, especially in the case of derivatives, in reducing the uncertainty and risk associated with financial reporting. Based on this question, the purpose of the empirical research is to assess the level of different risks which banks operating in Hungary face when using derivative financial instruments and to investigate how and to what extent relevance and faithful representation is affected. To answer this, a random effect regression model is conducted to verify whether or not the banks under consideration in Hungary were at risk or not as a result of their use of derivatives during the period from 2003 to 2012. The results indicate that the use of futures, forwards, and swaps tend to mildly increase liquidity, leverage, and credit risks, while options negatively affect leverage, liquidity and credit risks. Other derivatives have a negative effect on bank risks as well. There is some evidence that the relationship between the use of derivatives and overall risk is not significant; hence the banks in the sample are not put at risk by using different derivatives. In sum, it can be concluded that fair valuation of these instruments satisfies the fundamental requirements of useful financial information.