Quantitative market risk disclosure, bond default risk and the cost of debt: Why value at risk

This study investigates the impact of SEC-mandated quantitative market risk disclosure (SEC, 1997) on bond default risk and the firm's cost of issuing debt. The effects of the firm's current risk management performance and of the risk disclosure formats are examined.; These issues are examined by evaluating the relationship of changes in firms' quantitative market risk disclosures to bond default risk and bond risk premium for new issues and changes in bond risk premiums for seasoned bond issues of the affected companies. Changes in bond default risk and bond risk premium are also investigated across two different risk disclosure formats: sensitivity analysis and value at risk.; For new debt issues, the empirical results indicate that the first report of quantitative market risk disclosure is associated with bond default risk and cost of issuing debt differently, depending on success in hedging. After controlling other market risk factors, default risk and cost of capital increased for the speculative and/or the ineffective hedging firms, but decreased for the effective hedging firms. The results seem quite robust to alternative measures of hedging and speculation. These findings highlight the importance of reporting the effectiveness of a firm's hedging strategy under FAS No. 133.; The empirical analyses related to seasoned bond issues reveal that quantitative market risk disclosure is on average, associated with an increase in the cost of debt capital. When mixed results are obtained, for bonds issued by hedging firms, the speculative firms show a relatively high cost of debt capital both in level and changes during the development of the SEC regulation.; The empirical analyses on both new and seasoned debt issues show that the reduction in bond default risk and cost of debt is observed more frequently with the value at risk format than with sensitivity analysis. Firm size might be a confounding factor, however, because larger firms choose to disclose more value at risk than sensitivity analysis.