Managerial Risk Preferences Research Articles

Does size and book-to-market contain intangible information about managerial incentives? Learning from corporate D&O insurance purchase

Using 2008–2018 data for all publicly-listed firms in Taiwan, this paper tests for asymmetric information in the Directors' and Officers' (D&O) liability insurance market. We argue that size and book-to-market ratio contain information such as managerial risk preferences and their intention to reduce litigation risk. Our results show that a negative relationship exists between litigation risk and insurance purchase among small and low book-to-market firms. Our findings pinpoint out the importance of using size and the book-to-market ratio when detecting asymmetric information in the corporate level.

Moral hazard and risk-taking incentives in Islamic banks, does franchise value matter!

PurposeThis paper aims to examine risk-taking in Islamic banks by exploring moral hazard and owner/manager agency problems simultaneously.Design/methodology/approachThe authors propose to estimate a model of bank risk-taking that includes both franchise value and ownership structure as explanatory factors of bank risk.FindingsThe results show that franchise value is an important determinant of Islamic bank risk-taking. Banks with high franchise values are less likely to take risks than banks with low franchise value. In contrast, outside block holders have, at best, limited influences on bank risk-taking.Originality/valueThis paper conducts the first empirical examination of the relationship between managerial risk preferences and Islamic banks ownership. The authors examine simultaneously the effect of franchise value and owner/manager problem on Islamic bank risk taking behavior. They consider separately the impact on total risk, systematic risk and bank specific risk.

The Cross-Section of Managerial Ability, Incentives, and Risk Preferences

The Cross-Section of Managerial Ability, Incentives, and Risk Preferences

How do auditors perceive CEO's risk-taking incentives?

Prior literature documents that executive compensation influences managerial risk preferences through executives’ portfolio sensitivities to changes in stock prices (delta) and stock-return volatility (vega). Large deltas discourage managerial risk-taking, while large vegas encourage risk-taking. Theory suggests that auditors charge higher audit fees when standard audit procedures do not allow auditors to reduce audit risk including the risk arising from higher business risk. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and audit fees. We also find a negative relation between CEO portfolio deltas and the issuance of going-concern audit opinions (GCO).

Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function

Abstract The Great Recession focused attention on large financial institutions and systemic risk. We investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, we estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. We evaluate the costs and competitive implications of breaking up the largest banks into smaller banks.

Tailoring seasonal climate forecasts for hydropower operations

Abstract. Integration of seasonal precipitation forecasts into water resources operations and planning is practically nonexistent, even in regions of scarcity. This is often attributable to water manager's tendency to act in a risk averse manner, preferring to avoid consequences of poor forecasts, at the expense of unrealized benefits. Convincing demonstrations of forecast value are therefore desirable to support assimilation into practice. A dynamically linked system, including forecast, rainfall-runoff, and hydropower models, is applied to the upper Blue Nile basin in Ethiopia to compare benefits and reliability generated by actual forecasts against a climatology-based approach, commonly practiced in most water resources systems. Processing one hundred decadal sequences demonstrates superior forecast-based benefits in 68 cases, a respectable advancement, however benefits in a few forecast-based sequences are noticeably low, likely to dissuade manager's adoption. A hydropower sensitivity test reveals a propensity toward poor-decision making when forecasts over-predict wet conditions. Tailoring the precipitation forecast to highlight critical dry forecasts minimizes this inclination, resulting in 97% of the sequences favoring the forecast-based approach. Considering managerial risk preferences for the system, even risk-averse actions, if coupled with forecasts, exhibit superior benefits and reliability compared with risk-taking tendencies conditioned on climatology.

Executive Compensation and the Maturity Structure of Corporate Debt

ABSTRACTExecutive compensation influences managerial risk preferences through executives' portfolio sensitivities to changes in stock prices (delta) and stock return volatility (vega). Large deltas discourage managerial risk‐taking, while large vegas encourage risk‐taking. Theory suggests that short‐maturity debt mitigates agency costs of debt by constraining managerial risk preferences. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and short‐maturity debt. We also find that short‐maturity debt mitigates the influence of vega‐ and delta‐related incentives on bond yields. Overall, our empirical evidence shows that short‐term debt mitigates agency costs of debt arising from compensation risk.

The Cross-section of Managerial Ability, Incentives, and Risk Preferences

I estimate a dynamic investment model for mutual managers to study the cross-sectional distribution of ability, incentives, and risk preferences. The manager's compensation depends on the size of the fund, which fluctuates due to fund returns and due to fund flows that respond to the fund's relative performance. The model provides an economic interpretation of time-varying coefficients in performance regressions in terms of the structural parameters. I document that the estimates of fund alphas are precise and virtually unbiased. I find substantial heterogeneity in ability, risk preferences, and pay-for-performance sensitivities that relates to observable fund characteristics.

Executive Compensation, Hubris, Corporate Governance: Impact on Managerial Risk Taking and Value Creation in UK High-Tech and Low-Tech Acquisitions

While the traditional agency model assumes managerial risk aversion and under-investment in high tech opportunities, the behavioural agency model allows for risk seeking by managers leading possibly to over-risky investments. Corporate governance mechanisms can correct both under- and over-risky investment thereby ensuring value enhancing high tech acquisitions. Our study builds an empirical optimal risk model to identify the drivers of managerial risk taking by comparing UK high tech and low tech acquisitions. We then classify actual acquisitions into optmally risky, over-risky and under-risky acquisitions. We test whether under-risky and over-risky acquisitions underperform optimally risky ones in terms of 3-year post-acquisition shareholder wealth gains. Our main results demonstrate that almost none of the compensation contracts has an impact on managerial risk preferences in acquisitions while LTIP share awards discourage high risk acquisitions. Good past performance, stock market glamour status and flattering media profile that enhance managerial hubris make acquirer managers risk-seekers. Corporate governance structure does not have a material impact on managers' acquisition risk preferences. We find that over-risky investments create more value than under-risky or optimally risky acquisitions especially during the stock market boom of the late 1990s. During such a boom strategic use of stock as acquisition currency seems to avoid value destruction but not in other time periods.

Determinants of Managerial Risk: Exploring Personality and Cultural Influences

A risk-assessment instrument using 10 business scenarios that varied the risk dimensions of outcome uncertainty, personal exposure, outcome potential, and personal expectations was used to test the effects of individual risk preferences on managerial risk propensity among 285 Indian managers in India and Singapore. Additionally, the effects of individual and organizational characteristics on managerial risk preferences were measured. Blockwise regression analysis revealed that the following groups of managers were significantly more willing than others to take risks: male managers, managers in India, managers with more modern cultural values, managers working in organizations with higher perceived risk willingness, managers with a higher need for achievement, and Type A managers. Individual risk willingness preferences were also found to influence managerial beliefs about the perceived riskiness of risk-related decisions.

Capital structure and small public firms

Most analyses of capital structure, from both a theoretical and an empirical viewpoint, focus on large corporations. As a result of data-availability problems, empirical studies deal with large corporations. Theoretical frameworks typically use illustrations and casual empirical evidence involving large firms. Only limited amounts of research focus on small, growing, entrepreneurial corporations and the factors affecting the capital structures of these firms. Much of current theory in capital structure deals with factors that are not easily and objectively quantified by outside researchers. These factors include items such as expected bankruptcy costs, information asymmetries between management and the financial marketplace, agency costs of monitoring management, and managerial risk preferences. This paper reports on a survey sent to over 400 small, high-growth corporations. Questions on the survey were derived from various strands of the theoretical financial literature on capital structure. Over 27% of the surveys were completed and returned, and give insight into the motivations and preferences of chief financial officers from over 100 small, high-growth corporations. Examination of the responses shows that, contrary to financial theory, factors dealing with bankruptcy costs, agency costs, and information asymmetries play little, if any, major role in affecting capital structure policy. Rather, the responding financial officers seem to follow a “pecking order” in financing their firm's needs (use internal cash as much as possible, issue debt if necessary, issue equity only as a last resort), while being concerned with market conditions and their own preferences. The following are implications of these findings. First, financial theory, which is more and more focusing on “micro” factors while still theorizing efficient “macro” markets, may be incorrectly ignoring the effect that management risk perceptions and preferences play in making capital structure decisions. Thus, additional work is necessary to include the management in theories of capital structure. Second, this survey allows outsiders to peer inside the managerial black box and gain insight into the factors that motivate and impact capital structure decisions. It provides an empirical basis to help determine which influences are important. Third, managers of entrepreneurial firms and investors in venture capital can compare their own beliefs, perceptions, and motivations against the mean results obtained from our sample of high-growth firms.

Managerial Risk Preferences, Real Pension Costs, and Long-Run Corporate Pension Fund Investment Policy

This paper presents a new methodology for determining long-run corporate pension fund investment policy for a salary-based defined benefit pension plan. A mean-risk dominance model is developed to choose among the ex ante distributions of pension costs. The model identifies the optimum pension portfolio mix that is consistent with the cost objectives of the plan. The optimum mix consists of a minimum investment in stocks, ranging from a low of 40 percent to a high of 100 percent, depending on the risk preferences of the decision agent and corporate pension cost policies. The results are not sensitive to the age structure of the plan population.

Managerial Risk Preferences for Below-Target Returns

This paper reports on the risk preferences for below target returns of 224 managers from the U.S. Canada, and Europe. When only non-ruinous losses were involved, 71% of the managers were risk seeking for below target returns. The distribution of risk preferences tended to be stable over a wide range of experimental conditions: diversity of background of the managers, the size of outcomes below target, and the context of the decision process (personal versus managerial). When ruinous losses were introduced for 75 of the managers, 64% switched to risk averse behavior. Empirical findings concerning the relationship between risk preferences for below target returns and several demographic characteristics of managers are also reported.

An Unequal-Period Model for Cash Management Decisions

A lack of synchronization between cash inflows and outflows presents the problem of investing positive net flows and financing negative net flows. In addition to the basic investment-financing issue there are other interrelated problems such as the payment schedule and the minimal cash balance that directly affect cash management decisions. Previous attempts to solve these problems have imposed constraints that limit their application. The purpose of this study is to develop an applicable method for solving the cash management problem by deriving a linear programming model that is divided into unequal periods. The unequal time division maintains the day-to-day aspect of the problem while reducing the number of periods and variables to a manageable size. Decision variables are divided into four groups: the payment schedule, securities transactions, short-term financing, and the cash balance. The model determines the optimal values of these variables subject to institutional constraints and within a framework of managerial risk preferences that are expressed as subjective constraints and subsequently evaluated by the dual model. Although a certainty assumption is made, inputs are analysed by sensitivity analysis and the dual model, while the effects of uncertainty are further reduced by the unequal time structure of the model. Tests of the model indicate that it is both profitable and generally applicable by most business firms.