Managerial Risk Aversion Research Articles

Effect of Tax Avoidance Activities on Firm-Specific Risk

Does firm-specific risk increase as firms become more tax aggressive? Risky tax positions entail high probability that they will not be sustained upon examination, disallowing firms to claim benefits under these tax strategies and making it difficult for investors to predict firm’s future profitability. In this study, I find that idiosyncratic volatility, proxy for firm-specific risk, is negatively associated with effective tax rates. These results are robust to alternative variable definitions and model specifications. Results from two-stage least square regression and evidence from a natural experiment setting (implementation of FASB Interpretation No. 48) establish a direct and causal effect of tax aggressiveness on idiosyncratic volatility. The effect of risky tax strategies on idiosyncratic volatility lasts for long periods (up to seven years). Managerial risk aversion plays an important role in determining whether a firm will invest in risky tax strategies. Additional analyses show that the relation between firm-specific risk and tax aggressiveness is weaker when CEO ownership is high, and stronger when CEOs are compensated with options or when institutional ownership is high. The positive relation between tax aggressiveness and firm-specific risk is more pronounced for financially constrained firms, younger firms, firms that do not pay dividends, and technology firms.

Predicting reference points and associated uncertainty from life histories for risk and status assessment

To assess status of fish populations and the risks of overexploitation, management bodies compare fishing mortality rates and abundance estimates with reference points (RP). Generic, “data-poor” methods for estimating RP are garnering attention because they are faster and cheaper to implement than those based on extensive life history data. Yet data-poor RP are subject to many unquantified uncertainties. Here, we predict fishing mortality RP based on five levels of increasingly comprehensive data, to quantify effects of parameter and structural uncertainty on RP. Level I RP (least data) are estimated solely from species' maximum size and generic life history relationships, while level V RP (most data) are estimated from population-specific growth and maturity data. By estimating RP at all five data levels, for each of 12 North Sea populations, we demonstrate marked changes in the median RP values, and to a lesser extent uncertainty, when growth parameters come from data rather than life history relationships. As a simple rule, halving the median level I RP gives almost 90% probability that a level V median RP is not exceeded. RP and uncertainty were substantially affected by assumed gear selectivity; plausible changes in selectivity had a greater effect on RP than adding level V data. Calculations of RP using data for successive individual years from 1984 to 2014 showed that the median RP based on data for any given year would often fall outside the range of uncertainty for RP based on data from earlier or later years. This highlighted the benefits of frequent RP updates when suitable data are available. Our approach provides a quantitative method to inform risk-based management and decisions about acceptable targets for data collection and quality. Ultimately, however, the utility and extent of adoption of data-poor methods for estimating RP will depend on the risk aversion of managers.

Product market competition and corporate investment decisions

Purpose – The study aims to examine the association between product market competition and corporate investment decisions on, particularly, risk-taking and investment efficiency. Existing theoretical studies on whether product market competition mitigates or exacerbates agency problems are inconclusive. Prior research generally finds that competition constrains management opportunism in reporting operating performance. However, the association between product market competition and managerial investment decisions has largely been unexplored. Design/methodology/approach – The primary measure of product market competition is the Herfindahl–Hirschman Index. The authors use regression analysis to examine the association between corporate risk-taking and over-investment of free cash flow (FCF) (as dependent variables) and product market competition (as an independent variable). Findings – Using firm-year observations from 1990 to 2010, the authors find that competition encourages managers to invest in risky investment. They also find that competition disciplines management on its use of FCFs. Overall, their results provide support for the disciplining role of product market competition in management investment decisions. The results are robust after they control for shareholder activism and executive compensations. Originality/value – The paper contributes to the literature by providing evidence of the disciplining role of product market competition in management investment decisions. First, the results suggest that competition encourages managers to invest in risky investment. One potential explanation for the results is that competition reduces opportunities for resource diversion for management personal benefits and, in turn, decreases management risk aversion. Another explanation is that competition forces management to take more risks for the long-term survival of the company. Second, the results indicate that competition disciplines management on its use of FCFs. Although firms in highly competitive industries make investment decisions that are less conservative, they tend to avoid suboptimal investment decisions, such as over-investment of FCF, compared to their counterparts.

CEOs’ Tendency towards Risk-aversion and Currency Risk Management in Korea : Focusing on the Structured Derivatives

CEOs’ Tendency towards Risk-aversion and Currency Risk Management in Korea : Focusing on the Structured Derivatives

Executive Compensation and the Market Valuation of Managerial Attributes

How do the labor market values of executives’ personal traits evolve over time? We propose and estimate an interactive fixed effects model, which allows for time-variant valuation of unobserved manager attributes. We find that managerial talent is the most important unobserved trait determining compensation. The pay premium based on each talent decile has significant time variation that co-moves with the stock market. Such pay premium is concentrated among top talented managers, with executives at the median level of talent earning $241,000 total pay premium and those at the top talent decile earning $1,136,000. We also identify a second economically important executive trait, and this trait is related to managerial cautiousness or risk aversion. The pay premium of this trait is linked to the time variation in the equity market risk premium, with cautiousness being discounted (compensated) during the low (high) risk premium period.

Auditor industry specialization and corporate risk-taking

Purpose– The purpose of this study is to examine the effects of higher-quality auditors on corporate risk-taking.Design/methodology/approach– Agency theory suggests that managers have incentives to avoid risk in the interests of perquisite consumption and self-preservation, while investors prefer that managers invest in all projects with a positive net present value, i.e. projects that generally increase corporate risk. Empirical literature finds that managerial risk-aversion is mitigated (and firm value enhanced) when investor protection is higher. The authors examine whether higher-quality auditing is one such mechanism to encourage shareholder-focused corporate risk-taking. They model measures of corporate risk as a function of whether a firm is audited by an industry specialist or not, controlling specifically for accounting quality. They then examine the incremental effect of higher-quality audits on other forms of external monitoring (analyst coverage and institutional holdings) for corporate risk.Findings– Using a sample from 2003 to 2007, the authors document a positive relationship between local-level audit industry specialization and both the standard deviation of annual stock returns and research and development expenditures (their measures of corporate risk-taking). They then find the effect is mitigated when firms have alternative external monitoring, in the form of either higher analyst coverage or greater institutional holdings.Research limitations/implications– Given the nature of the question the authors ask, particularly in the context of the auditor–client relationship, a potential limitation is the difficulty in assigning causation. Nonetheless, this study underscores the importance of auditors as an effective mechanism for monitoring corporate managers.Originality/value– This study provides novel evidence that auditors affect managerial decision making beyond a simple effect on financial statements, and should be of interest to boards of directors, regulators and investors.

CONVEXITY, MAGNIFICATION, AND TRANSLATION: THE EFFECT OF MANAGERIAL OPTION‐BASED COMPENSATION ON CORPORATE CASH HOLDINGS

AbstractUsing the distinctions among the convexity, magnification, and translation effects, we identify the pertinent parameters and examine empirically the relation between cash holdings and option‐based managerial compensation. We show that changes in delta reduce the effects of magnification and convexity on managerial risk aversion. We also provide evidence that there is a negative relation between the option‐based incentives delta and vega and cash holdings. These results are robust when incentives are extended to include all executive board members and when the sample is broken down according to different risk characteristics.

Revisiting organizational age, inertia, and adaptability

Purpose– The literature of organizational change hints that adaptability and inertia not only counterbalance but also reinforce each other, and the inertia-adaptability balance over time is nonlinear. The author aims to address this view more clearly by presenting a multi-stage conceptual model that delineates how adaptability and inertia take turns to override each other. In addition, data collected from over 400 nonprofit organizations within the USA were used to test this model.Design/methodology/approach– This study uses polynomial regression to examine the multi-stage conceptual model. More precisely, it tests how organizational age influences an organization's innovativeness, managerial risk aversion, and red tape.Findings– The findings support the multi-stage conceptual model. The results imply that organizational ecology and rational adaptation are mutually compatible perspectives in explaining organizational age dynamics.Originality/value– This study introduces a multi-stage model that more clearly examines how adaptability and inertia counterbalance and reinforce over time. More importantly, the author empirically examines the nonlinear organizational age dynamics using quantitative data.

Incitations managériales et oligopole : quels sont les effets de la compétence et des bénéfices privés de contrôle

Nous considerons, dans cet article, une industrie oligopolistique composee de deux groupes (ou classes) de proprietaires de firmes qui produisent des biens differencies. Dans un groupe, les proprietaires ont un pouvoir de controle qui leur permet d’extraire des benefices prives. Par contre, les managers s’opposent a la formation de ces benefices. Dans l’autre groupe, les proprietaires ne sont pas interesses par les benefices prives. Par ailleurs, chaque proprietaire embauche un manager pour reduire son cout marginal, mais il (ou elle) ne peut pas observer l’effort du manager. Il s’agit alors de montrer en quoi la competence manageriale, l’aversion pour le risque et les benefices prives peuvent jouer un role important dans les variables de decisions de la firme, telles que l’intensite incitative, la quantite et le prix, mais egalement l’effort du manager et sa remuneration ; et de voir en quoi ils peuvent influencer les performances des deux groupes dans le cadre d’une approche comparative.

Options, option repricing in managerial compensation: Their effects on corporate investment risk

While stock options are commonly used in managerial compensation to provide desirable incentives, they can create adverse incentives to distort the choice of investment risk. Relative to the risk level that maximizes firm value, call options in a compensation contract can induce too much or too little corporate risk-taking, depending on managerial risk aversion and the underlying investment technology. We show that inclusion of lookback call options in compensation packages has desirable countervailing effects on managerial choice of corporate risk policies and can induce risk policies that increase shareholder wealth. We argue that lookback call options are analogous to the observed practice of option repricing.

Corporate Governance and Corporate Social Responsibility Disclosure: Evidence from the US Banking Sector

There is a distinct lack of research into the relationship between corporate governance and corporate social responsibility (CSR) in the banking sector. This paper fills the gap in the literature by examining the impact of corporate governance, with particular reference to the role of board of directors, on the quality of CSR disclosure in US listed banks’ annual reports after the US sub-prime mortgage crisis. Using a sample of large US commercial banks for the period 2009–2011 and controlling for audit committee characteristics, board meeting frequency, and banks’ profitability, size and risk, we find evidence that board independence and board size, the two board characteristics usually associated with the protection of shareholder interests, are positively related to CSR disclosure. This indicates that, with regard to CSR disclosure, more independent boards of directors and larger boards are the internal corporate governance mechanisms which promote both shareholders’ and other stakeholders’ interests. Contrary to our expectations, CEO duality also impacts positively on CSR disclosure. From an agency-theoretical viewpoint, this suggests that powerful CEOs may promote transparency about banks’ CSR activities for their private benefits. While this could indicate that powerful CEOs are under particular pressure to appease stakeholders’ concerns that they might abuse their power by providing a high degree of CSR disclosure, it could also be a sign of managerial risk aversion or managers’ private reputational concerns.

Diversification in Private Equity Funds: On Knowledge Sharing, Risk Aversion, and Limited Attention

AbstractThis paper examines diversification as a source of value creation and destruction in private equity (PE) funds. Previous literature has focused on the “diversification discount” in corporations. However, in PE funds, diversification might increase returns by ameliorating managerial risk aversion and facilitating knowledge sharing. I examine a sample of 1,505 PE funds and show that industry and geographic diversification can increasePE fund returns. This is likely due to knowledge sharing and learning, not merely risk reduction. Diversification can reduce returns if it spreads staff too thinly across industries or is motivated by risk aversion rather than performance bonuses.

Sorting Effects of Performance Pay

Compensation not only provides incentives to an existing manager, but also affects the type of manager attracted to the firm. This paper examines the dual incentive and sorting effects of performance pay in a simple contracting model of endogenous participation. In general, sorting dampens optimal pay-performance sensitivity (PPS), as PPS beyond a nominal amount transfers unnecessary (information) rent to the manager. This helps explain why empirical estimates of PPS are much lower than predictions from models of moral hazard alone. The model also predicts that sorting under asymmetric information causes the firm to turn away more candidates than would be efficient; PPS increases in the cost of hiring the manager and in the manager's outside option, but decreases in output risk, information risk, and managerial risk-aversion; the firm becomes more selective in hiring as either the manager's outside option, the cost of hiring, risk-aversion, output risk, or information risk increases.

Banking Capital and Risk-Taking Adjustment under Capital Regulation: The Role of Financial Freedom, Concentration and Governance Control

This study analyzes the relevance of capital adjustment and risk-taking adjustment during the financial tsunami when the banking industry was under capital regulation. Using the panel data of commercial banks in the USA and non-USA from 2003 to 2009, we consider the effects of financial freedom, concentration and governance control simultaneously by three-stage least square analysis. The results show that capital and risk adjustment are positively correlated for both USA and non-USA banking industry, which are consistent after the financial tsunami. This applies to the verification of the capital buffer theory. In addition, for banks with low capital adequacy ratio, capital and risk adjustment are negatively correlated. This applies to the verification of bankruptcy cost avoidance theory and managerial risk aversion theory. Finally, banks with lower capital ratio will be faster in the adjustment of risk-taking as compared with banks with higher capital ratio. This study recommended that supervision should be coupled with governance control to achieve the goal of reducing risk-taking.

Takeover defenses, innovation, and value creation: Evidence from acquisition decisions

The desirability of antitakeover provisions (ATPs) is a contentious issue. ATPs might enable managerial empire building by insulating managers from disciplinary takeovers. However, some companies, such as �hard-to-value� (HTV) companies, might trade at a discount due to valuation difficulties, thereby exposing HTV companies to opportunistic takeovers and creating agency conflicts of managerial risk aversion. ATPs might ameliorate such managerial risk aversion by inhibiting opportunistic takeovers. This paper analyzes acquisitions made by HTV firms, focusing on whether the acquirer (not the target) is entrenched in order to examine the impact of entrenchment managerial decision making. The results show that HTV firms that are entrenched make acquisitions that generate more shareholder wealth and are more likely to increase corporate innovation, suggesting that ATPs can be beneficial in some firms.

Entrenchment or incentive? CEO employment contracts and acquisition decisions

A long-standing controversy is whether CEO employment contracts insulate inferior managers from discipline leading to shareholder wealth destruction, or whether contracts alleviate managerial risk aversion and encourage value-enhancing decisions. Using a unique dataset on S&P 500 CEO employment contracts during 1993–2005, I find that acquirers with a CEO contract obtain better announcement returns, pay lower premiums for their targets, garner superior long-run post-acquisition operating performance, and undertake riskier deals than acquirers without a contract. Further investigation of individual contract provisions reveals substantial heterogeneity. Specifically, the fixed term rather than at will contract, longer contract duration, long-term equity incentives, accelerated stock and option vesting provisions in severance arrangement, and more refined definitions of just cause (good reason) for CEO termination (resignation) alleviate managerial risk aversion, reduce contracting ambiguity, and motivate value-creating decisions.

Managerial Risk Aversion and Vertical Integration

In this paper, we provide a new explanation for vertical integration decisions and the wealth effects of those decisions. Our hypothesis is based on managerial risk aversion. Agency theory posits that differences in risk preferences between managers and shareholders can impose costs on shareholders. Using CEO relative inside leverage (the ratio of the CEO’s inside leverage to firm leverage) to proxy for managerial risk aversion, we find that CEOs with higher relative inside leverage are more likely to engage in vertical mergers. Furthermore, vertical acquisitions made by CEOs with higher relative inside leverage generate lower announcement returns, and this negative effect of CEO relative inside leverage on acquisition returns for shareholders is more pronounced when the acquirer has a higher degree of informational opacity, weak corporate governance, excess cash holdings, and higher cash-flow volatility. Further analyses show that CEOs with large inside debt holdings tend to overpay in vertical acquisitions, which might be one channel through which such acquisitions damage shareholder wealth. Our study provides new evidence on how managerial objectives affect shareholder wealth in merger and acquisitions.

Managerial attitudes and corporate actions

We administer psychometric tests to senior executives to obtain evidence on their underlying psychological traits and attitudes. We find US CEOs differ significantly from non-US CEOs in terms of their underlying attitudes. In addition, we find that CEOs are significantly more optimistic and risk-tolerant than the lay population. We provide evidence that CEOs' behavioral traits such as optimism and managerial risk-aversion are related to corporate financial policies. Further, we provide new empirical evidence that CEO traits such as risk-aversion and time preference are related to their compensation.

On risk management determinants: what really matters?

We develop a theoretical model in which debt and hedging decisions are made simultaneously, and test its predictions empirically. To address inefficiencies in current estimation methods for simultaneous equations with censored dependent variables, we build an original estimation technique based on the minimum distance estimator. Consistent with predictions drawn from our theoretical model, we show that more hedging does not always lead to a higher debt capacity. We also find that financial distress costs, information asymmetry, the presence of financial slack, corporate governance, and managerial risk aversion are important determinants of corporate hedging. Overall, our evidence shows that modeling hedging and leverage as simultaneous decisions makes a difference in analyzing corporate hedging determinants.

Managerial Incentives, Risk Aversion and Corporate Policy Decisions

We provide new evidence that equity incentives can have perverse effects on firm value. Conditioning the relationship between chief executive officer (CEO) incentives and the risk exposure generated by corporate policy decisions on how risk is expected to affect firm value, we find that delta encourages value-maximising investment and firm focus policy decisions, but may lead to sub-optimal financing decisions. When the goal of value-maximisation conflicts with the CEO’s propensity to avoid risk, the incentive effect of delta partially offsets risk aversion. We show that while CEO incentives affect corporate policy, the firm’s optimal policy also influences the compensation contract.