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The increasing importance of derivatives to financial institutions (including banks that are dealers of these instruments), as well as to other enterprises, has heightened the need to understand them better. Public awareness of these instruments has also grown, a consequence of highly publicized losses by some large businesses and municipalities that had entered into derivative contracts. In a few instances, the losses were blamed on derivatives even though they had in fact resulted from the trading of traditional financial instruments. Nevertheless, these events illustrate the need for firms entering into contracts, shareholders of these firms, policymakers, and the public to understand derivative instruments more fully. The risks associated with derivatives are no different from the risks that firms have always had to recognize and control (see box ‘‘Risks Associated with Derivatives’’). All financial contracts carry some degree of risk. Nonderivative contracts, in fact, can be riskier and more complex than derivatives. For example, a junk-rated bond that is tied to a foreign interest rate and is convertible into the issuer’s common stock carries credit and market risk that would be difficult to quantify. In contrast, the risks of some derivatives, such as futures contracts, can be easily assessed because prices are observable from trading on exchanges and cash changes hands daily to maintain collateral, mitigating credit risk. Nonetheless, derivatives can be highly complex in their design, and their pricing can be opaque, making their risks difficult to understand, measure, and manage. One approach to increasing public understanding of derivatives has been the implementation of more comprehensive accounting practices and disclosure requirements. In particular, these two tools are helpful in characterizing more accurately the effects of these instruments on firms’ financial performance and in explaining those effects through public financial reporting. The benefits of these tools are not limited to derivatives, however. They should also lead to better understanding of how firms manage risks arising from nonderivative financial contracts as well as from other sources. The goals are to demystify derivatives, to facilitate the assessment of firms’ derivatives activities by readers of financial statements, and thereby to help improve the allocation of capital by financial markets. Many groups have been involved in bringing about changes in derivatives accounting and reporting: authorities that set accounting standards, regulators and bank supervisors, and industry associations. These groups have set various regulatory requirements and have made numerous recommendations (see box ‘‘Requirements and Recommendations for Public Disclosure’’). As a result, the nature of the information publicly disclosed by firms has been evolving in several ways, including the amount and type of information disclosed and the way information is presented. The published annual reports to shareholders and other public financial reports of banks and other companies play an important role in disseminating information to investors, creditors, and other stakeholders in the enterprises. The information they convey about derivatives has improved significantly in the past few years. A survey of the annual reports of the top ten U.S. banks that deal in derivatives showed that their 1994 reports were substantially more ‘‘transparent’’ than their 1993 reports, with more discussion and analysis of, and more quantitative information about, their use of these instruments. 2

Derivatives Disclosures by Major U.S. Banks, 1995