1. Implementation of Risk Management Strategies <ul><li>Organizing and motivating employees to take prudent risks </li></ul><ul><ul><li>Developing incentives consistent with a risky environment. </li></ul></ul><ul><ul><li>Decentralization and the risk of “gambler’s ruin”. </li></ul></ul><ul><li>Evaluating risk attitudes </li></ul><ul><ul><li>Systematically assessing utility functions. </li></ul></ul><ul><ul><li>Applying utility functions to real world problems. </li></ul></ul>
2. Incentives for Risky Decisions <ul><li>Middle management may be conservative (risk averse) because they use their own outcomes rather than the company’s outcomes as the basis for decisions. </li></ul>Sure Thing Risky Alternative Success .5 Failure .5 Manager’s Outcomes Promotion Fired Pat on Back Company’s Outcomes $1,000,000 -$100,000 $100,000
3. Decentralization and “Gambler’s Ruin” <ul><li>Decentralization has the advantage of making the most knowledgeable individuals responsible for decisions. </li></ul><ul><li>In a risky environment, decision makers may become too conservative because of the fear of “gambler’s ruin”. </li></ul>
4. <ul><li>Example: Suppose in Algeria there are 100 prospects with the following description: </li></ul><ul><li>Suppose Algeria is decentralized into 20 fields, each with a drilling budget of $5,000,000. </li></ul><ul><li>If a manager decides to spend his budget drilling 5 of these prospects in a year, the P(no discovery) is 0.80 5 =0.33. </li></ul><ul><li>Compare this to the P(no discovery) in the centralized firm, that is, 0.80 20 =0.01 </li></ul><ul><li>Decentralization requires the implementation of one of the two alternative personnel evaluation plans described below to avoid conservative decision making. </li></ul>Success (0.2) Failure (0.8) $10,000,000 -$1,000,000 EV = $1,200,000
5. Establishing Appropriate Incentives <ul><li>Alternative 1: Managers must be given the opportunity to develop a track record over a large number of risky decisions. </li></ul><ul><li>Alternative 2: Managers must be evaluated on the basis of their decisions rather than on the basis of the outcomes. </li></ul><ul><ul><li>Making the distinction between decision and outcome allows us to separate action from consequence - and hence improve the quality of action. </li></ul></ul><ul><ul><li>Requires a more sophisticated personnel evaluation system. </li></ul></ul><ul><ul><li>Encourages documentation of the basis of decisions at the time they are made, and before the outcomes are known. </li></ul></ul><ul><ul><li>Encourages more group decision making, and the responsibility for risky decisions is shared. </li></ul></ul>
6. Limitations of Expected Value <ul><li>The Firm Does not Possess an Unlimited Pool of Exploration Capital </li></ul><ul><li>The Firm is Not Risk Neutral </li></ul><ul><li>EMV Fails to Provide Guidance on Limiting the Downside Exposure. </li></ul>
7. EMV - Unlimited Pool of Capital? <ul><li>Firm has an Exploration Budget of $20 Million and the Opportunity to Invest in the Following Four Drilling Prospects: </li></ul><ul><li>Prospect Outcome Value Probability EMV </li></ul><ul><ul><li>1 Success $40mm 0.20 </li></ul></ul><ul><ul><ul><li>Dry Hole -$5mm 0.80 $4mm </li></ul></ul></ul><ul><ul><li>2 Success $15mm 0.10 </li></ul></ul><ul><ul><ul><li>Dry Hole -$5mm 0.90 -$3mm </li></ul></ul></ul><ul><ul><li>3 Success $20mm 0.50 </li></ul></ul><ul><ul><ul><li>Dry Hole -$8mm 0.50 $6mm </li></ul></ul></ul><ul><ul><li>4 Success $80mm 0.25 </li></ul></ul><ul><ul><ul><li>Dry Hole -$20mm 0.75 $5mm </li></ul></ul></ul>
8. Unlimited Pool of Capital? <ul><li>EMV Decision Rule: Invest in Prospects 1, 3 & 4. </li></ul><ul><li>Total Required Capital: $33 million </li></ul><ul><li>Total Exploration Budget: $20 million </li></ul><ul><li>Deficiency $13 million </li></ul><ul><li>How do we Choose Among (Rank) Prospects with Positive Net Present Values? </li></ul>
9. EMV - The Firm is Risk Neutral? <ul><li>Consider the Following Decision Alternatives </li></ul><ul><ul><li>Fair Coin Flip: Heads: Win $2 </li></ul></ul><ul><ul><li>Tails: Lose $1 </li></ul></ul><ul><ul><li>Would you accept this Gamble? </li></ul></ul><ul><li>Your entire fortune is $10 million. You are offered the following fair coin flip: </li></ul><ul><ul><li>Fair Coin Flip: Heads: Win $20 million </li></ul></ul><ul><ul><li>Tails: Lose $10 million </li></ul></ul><ul><ul><li>Would you accept this Gamble? </li></ul></ul><ul><li>Most people say “YES” to the First Gamble and “NO” to the Second. </li></ul>
10. EV - Failure to Provide Guidance on Limiting Downside Exposure <ul><li>Consider the Following Two Drilling Ventures: </li></ul><ul><li>Expected Value of A = Expected Value of B? </li></ul><ul><li>EMV does not Consider the Magnitude of Money Exposed to the Chance of Loss. </li></ul>0.50 0.80 $200M -$40M $88M -$20M Prospect B Prospect A 0.20 0.50
11. Risk Methods Used in Making Decisions by Energy Companies (J. Battle, 1986)
12. A Comment on Risk-Adjusted Discount Rates <ul><li>No separation between risk discounting and time value of money discounting. </li></ul><ul><ul><li>Time and risk are logically separate variables. </li></ul></ul><ul><ul><li>Combining the variables into one risk-adjusted discount rate (RAD) can bias the valuation results. </li></ul></ul><ul><li>Inconsistencies with respect to risk and valuation where projects have different durations. </li></ul><ul><ul><li>Management may be biased against long-term projects. </li></ul></ul><ul><ul><li>Uncertainty must be resolved at a constant rate over time. </li></ul></ul><ul><li>Arbitrary methodologies for determination of RAD. </li></ul><ul><ul><li>The firm’s cost of capital does not represent a single project risk or even a specific class of projects. </li></ul></ul>
13. <ul><li>Risk-adjusted discount rate - An Example </li></ul>Long Life Venture .2 .8 -10 - 100/(1+ i) 3 + 500/(1+ i ) 10 -10 ($MM) Short Life Venture .2 .8 -10 + 60/1+ i -10 ($MM) Short Life Long Life Discount Rate NPV if Success NPV if Success 10% $44.5 MM $107.0 MM 20% $40.0 MM $ 12.8 MM <ul><li>Valuation bias caused by combining risk discounting and time value of money discounting . </li></ul>
14. Preference or Expected Utility Theory <ul><li>Dominant approach to the theory of decision making in both economics and finance. </li></ul><ul><li>Establishes the process of modeling an individual or firm’s risk propensity. </li></ul><ul><li>Enables decision maker to incorporate risk attitudes into the decision process. </li></ul><ul><li>Provides the firm a technique for determining the appropriate level of diversification. </li></ul>
15. Attitudes Toward Risk <ul><li>Most researchers believe that if certain basic behavioral assumptions hold, people are expected utility maximizers - that is, they choose the alternative with the largest expected utility. </li></ul><ul><li>An individual’s utility function is a mathematical function that transforms monetary values - payoffs and costs - into utility values . </li></ul><ul><li>Essentially an individual’s utility function specifies the individual’s preferences for various monetary payoffs and costs and, in doing so, it automatically encodes the individual’s attitudes toward risk. </li></ul>
16. Attitudes Toward Risk -- continued <ul><li>Most individuals are risk averse , which means intuitively that they are willing to sacrifice some EMV to avoid risky gambles. </li></ul><ul><li>Utility functions are said to be increasing and concave. This means they go uphill and they increase at a decreasing rate. </li></ul><ul><li>There are two problems in implementing utility maximization in a real decision analysis: </li></ul><ul><ul><li>The first is obtaining an individual's utility function. </li></ul></ul><ul><ul><li>The second is using the resulting utility function to find the best decision. </li></ul></ul>
17. Assessing a Utility Function <ul><li>To estimate a person’s utility function we present the person with a choice between the following two options: </li></ul><ul><ul><li>Option 1: Obtain a certain payoff of z (really a loss if z is negative) . </li></ul></ul><ul><ul><li>Option 2: Obtain a payoff of either x or y , depending on the flip of a fair coin. </li></ul></ul><ul><li>We ask the person to select the monetary value of z so that he or she is indifferent. This value is known as the indifference value . </li></ul>
18. The Session <ul><li>Susan first asks John for the largest loss and largest gain he can imagine. </li></ul><ul><li>He answers with values $200,000 and $300,000, so she assigns values U (-200000) = 0 and U (300000) = 1 as anchors for the utility function. </li></ul><ul><li>She presents John with the choice of two options: </li></ul><ul><ul><li>Option 1: Obtain a payoff of z (really a loss if z is negative) </li></ul></ul><ul><ul><li>Option 2: Obtain a loss of $200,000 or a payoff of $300,000, depending on the flip of a fair coin. </li></ul></ul>
19. The Session -- continued <ul><li>Susan reminds John that the EMV of option 2 is $50,000 (halfway between $200,000 and $300,000). </li></ul><ul><li>He realizes this but since he is risk averse he would far rather have $50,000 for certain than take the risk in Option 2. Therefore the indifference value of z must be less than $50,000. </li></ul><ul><li>Susan then poses several values of z to John: </li></ul><ul><ul><li>Would he rather have $10,000 for sure or Option2? </li></ul></ul><ul><ul><ul><li>He said he would take the $10,000. </li></ul></ul></ul>
20. The Session -- continued <ul><ul><li>Would he rather pay $5,000 for sure or take Option 2. </li></ul></ul><ul><ul><ul><li>He says he would take Option 2. </li></ul></ul></ul><ul><li>By this time we know the indifference value is less than $10,000 and greater than -$5,000. </li></ul><ul><li>After a few more questions John finally decides on z= $5000 as his indifference value. </li></ul><ul><li>John is giving up $45,000 in EMV because of his risk aversion. The EMV of Option 2 is $50,000 and his willing to accept a sure $5000 in its place. </li></ul>
21. The Session -- continued <ul><li>The process continues until she helps John assess enough utility values to approximate a continuous utility curve. </li></ul><ul><li>As this example illustrate utility assessment is tedious and can even be more complicated for a company than for an individual because of the different attitudes of the executives. </li></ul>
22. Comments on Preference Assessment <ul><li>Choice among preference assessment procedures should be based on ease of use by the decision maker. </li></ul><ul><li>Assess preferences on outcomes that represent realistic ranges of outcomes for the decision maker. </li></ul><ul><li>Individuals are not perfectly consistent and since some risks are more meaningful than others, it makes sense to use the range that corresponds to the problem at hand. </li></ul><ul><li>Check for consistency of preferences. </li></ul>
23. <ul><li>Win $4000 with probability of 0.40 </li></ul><ul><li>Win $2000 with probability of 0.20 </li></ul><ul><li>Win $0 with probability of 0.15 </li></ul><ul><li>Lose $2000 with probability of 0.25 </li></ul><ul><li>Step 1. Find the Expected Utility </li></ul><ul><li>EU = 0.4U($4000) + 0.2U($2000) + </li></ul><ul><li>0.15U($0) + 0.25U(-$2000 </li></ul><ul><li>= 0.4(1) + .2(.81) + .15(.65) + .25(.4) </li></ul><ul><li>= 0.76 </li></ul><ul><li>Step 2. Find the certainty equivalent. </li></ul><ul><li>Approximately $900 </li></ul><ul><li>Step 3. Find the expected value. </li></ul><ul><li>EV = $1500 </li></ul><ul><li>Consider the following utility function and gamble. . . </li></ul>Step 4. Find the risk premium. Risk Premium = EV - CEQ $600 = $1500 - $900
24. <ul><li>What is the dominant choice, given the decision maker’s utility function? </li></ul><ul><li>Consider the following investment choices. . . </li></ul>A B .5 .7 .1 .4 .3 $10,000 $4,000 $0 $8,000 $2,000 EV = $6600 EV = $6200
25. Example 6.9 Incorporating Attitudes Toward Risk
26. Background Information <ul><li>Venture Limited is a company with net sales of $30 million. </li></ul><ul><li>The company currently must decide whether to enter one of two risky ventures or do nothing. </li></ul><ul><li>The possible outcomes of the less risky venture are a $0.5 million loss, a $0.1 million gain, and a $1 million gain. </li></ul><ul><li>The probabilities of these outcomes are 0.25, 0.50, and 0.25. </li></ul>
27. Background Information -- continued <ul><li>The possible outcomes of the more risky venture are a $1 million loss, a $1 million gain, and a $3 million gain. </li></ul><ul><li>The probabilities of these outcomes are 035, 0.60, and 0.05. </li></ul><ul><li>If Venture Limited can enter at most one of the two risky ventures, what should they do? </li></ul>
28. Risk Aversion - Functional Forms <ul><li>Utility functions might be specified in terms of a graph or utility curve. </li></ul><ul><li>Alternatively, utility functions may be expressed in terms of a mathematical form. </li></ul><ul><li>Three general categories of risk aversion and their mathematical form: </li></ul><ul><ul><li>Decreasing Risk Aversion (Log) u(x) = log (x + c) </li></ul></ul><ul><ul><li>Increasing Risk Aversion (Power) u(x) = x c </li></ul></ul><ul><ul><li>Constant Risk Aversion (Exponential) u(x) = -e -cx </li></ul></ul>
29. <ul><li>Constant Risk Aversion </li></ul><ul><ul><li>Condition which implies that the risk premium is the same for gambles that are identical except for adding the same constant to each payoff. </li></ul></ul><ul><ul><li>The risk premium does not depend on the initial amount of wealth held by the decision maker. </li></ul></ul>Expected Value = $5,000 Expected Utility = 0.32 CEQ = $2,800 Risk Premium = $2,200 where, p = 0.5 1 - p = 0.5 $20,000 -$10,000
30. <ul><li>Now consider again the case when we add a constant to each of the payoffs in the lottery. . . </li></ul>p = 0.5 1 - p = 0.5 $20,000 -$10,000 (A) $30,000 $0 (B) $40,000 $10,000 (C) $50,000 $20,000 (D) Expected Value: Expected Utility: Certainty Equivalent: Risk Premium: <ul><li>If we know the DM’s CEQ of only one lottery, we can easily determine the CEQ of any other lottery over the range. </li></ul><ul><li>It is reasonable to use the exponential utility function as an approximation in modeling preferences and risk attitudes. </li></ul>$5,000 0.32 $2,800 $2,200 $15,000 0.52 $12,800 $2,200 $25,000 0.68 $22,800 $2,200 $35,000 0.82 $32,800 $2,200
31. Exponential Utility <ul><li>One important class is exponential utility , which has only one adjustable numerical parameter, and there are straightforward ways to discover the most appropriate value of this parameter for an individual or company. </li></ul><ul><li>An exponential utility function has the following form: U ( x) = 1 - e -x/R </li></ul><ul><li>x is the monetary value, U ( x ) is the utility of this value and R>0 is an adjustable parameter called the risk tolerance . </li></ul>
32. Exponential Utility -- continued <ul><li>Risk tolerance measures how much risk the decision maker will tolerate. </li></ul><ul><li>To assess a person’s exponential utility function, we need only to assess the value of R . A couple tips for doing this are: </li></ul><ul><ul><li>The first tip is that the risk tolerance is approximately equal to that dollar amount R such that the decision made is indifferent between the following two options: </li></ul></ul><ul><ul><ul><li>Option 1: Obtain no payoff at all. </li></ul></ul></ul><ul><ul><ul><li>Option 2: Obtain a payoff of R dollars or a loss of R /2 dollars, depending on the flip of a fair coin. </li></ul></ul></ul>
33. Exponential Utility -- continued <ul><ul><li>The second tip is for finding R is based on empirical evidence found by Ronald Howard. He found that R was approximately 6.4% of net sales, 12.4% of net income, and 15.7% of equity for the company. </li></ul></ul><ul><ul><ul><li>These percentages are just guidelines. </li></ul></ul></ul><ul><ul><ul><li>They do indicate that larger companies have larger values of R . </li></ul></ul></ul>
34. Solution <ul><li>We will assume Venture Limited has an exponential utility function. </li></ul><ul><li>Based on Howard’s guidelines, we will assume that the company’s risk tolerance is 6.4% of its net sales, or $1.92 million. </li></ul><ul><li>Using the exponential utility formulas we can find the utility of any monetary outcome. </li></ul><ul><ul><li>The gain for doing nothing is $0 and its utility is 0. </li></ul></ul><ul><ul><li>The utility of a $1 million loss is -0.683. </li></ul></ul>
35. The Decision Tree <ul><li>PrecisionTree takes care of all the details of building the decision tree. </li></ul><ul><li>We label it in the normal way and then we click on the name of the tree to open a dialog box. </li></ul><ul><li>We then fill in the utility function information - an exponential utility function with risk tolerance 1.92. It also indicates that we want expected utilities (as opposed to EMVs) to appear in the tree. </li></ul>
36. VENTURE.XLS <ul><li>This file contains the input values for the tree. </li></ul><ul><li>We build it in exactly the same way as usual and link probabilities and monetary values to its branches in the usual way. </li></ul><ul><li>However, the expected values shown in the tree (those shown in color) are expected utilities and the optimal decision is the one with the largest expected utility. </li></ul>
37.
38. Interpretation <ul><li>The optimal decision is to invest in the less risky venture. </li></ul><ul><li>From an EMV point of view, the more risky venture is definitely best. </li></ul><ul><li>However, venture Limited is sufficiently risk averse, and the monetary values are sufficiently large, that the company is willing to sacrifice the EMV to reduce its risk. </li></ul>
39. Interpretation -- continued <ul><li>How sensitive is the optimal decision to the key parameter, the risk tolerance? </li></ul><ul><li>We can answer this by changing the risk tolerance and watching how the decision tree changes. </li></ul><ul><ul><li>When the risk tolerance increases to approximately $2.075 million the company is more risk tolerant. </li></ul></ul><ul><ul><li>When the risk tolerance decreases the “do nothing” decision becomes optimal. </li></ul></ul><ul><li>Thus we can see that the optimal decision depends heavily on the attitudes toward risk of Venture Limited’s top management. </li></ul>
40. Certainty Equivalents <ul><li>Now suppose Venture only had two options, enter the less risky venture or receive a certain dollar amount x and avoid the gamble altogether. </li></ul><ul><ul><li>If it enters the risky venture, its expected utility is 0.0525, calculated previously. </li></ul></ul><ul><ul><li>If it receives x dollars for certain, its expected) utility is approximately $0.104 million. </li></ul></ul><ul><li>This value is called the certainty equivalent of the risky venture. </li></ul>
41. Decision Tree with Certainty Equivalents
42. <ul><li>Risk Sharing - An Investment Example </li></ul><ul><li>Risk neutral evaluation indicates </li></ul><ul><li>a linear relationship between </li></ul><ul><li>share and expected value of </li></ul><ul><li>each alternative. </li></ul><ul><li>Project A dominates in all cases . </li></ul>Project B Project A .4 .1 .3 .2 $700,000 $100,000 -$50,000 -$450,000 .4 .1 .3 .2 $800,000 $200,000 -$100,000 -$500,000 $0 Invest Do not Invest EV = $210,000 at 100% EV(B) = $185,000 EV(A) = $210,000
43. <ul><li>Now suppose we use the following utility function. . . </li></ul>Project B Project A .4 .1 .3 .2 $700,000 $100,000 -$50,000 -$450,000 .4 .1 .3 .2 $800,000 $200,000 -$100,000 -$500,000 $0 Invest Do not Invest CEQ = $0 Do not Invest CEQ(B) = -$30,000 CEQ (A) = -$85,000 ...and analyze our investment problem on the basis of certainty equivalents. <ul><li>With no risk-sharing, do not take either project, since Project A has a CEQ of -$85,000 and Project B has a CEQ of -$30,000. </li></ul>
44. <ul><li>Now consider the CEQ evaluation at different project shares using our utility function. . . </li></ul><ul><li>With a 50-50 partnership, take Project “A” since it has a CEQ of $$50,000 and is better than Project “B” at that level of risk-sharing. </li></ul><ul><li>Provides valuable insights concerning firm’s optimal share in individual, as well as groups of, risky projects. </li></ul><ul><li>Willingness to participate in risky projects can be systematically incorporated into project evaluation. </li></ul>
45. Measuring Risk Tolerance <ul><li>Suppose the Firm Rejects Expected Monetary Value as the Basis for Making Risky Decisions. What do we do? </li></ul><ul><li>Our Goal is to Construct a Preference Scale that: </li></ul><ul><ul><li>Encodes the Firm’s Attitude Towards Financial Risk </li></ul></ul><ul><ul><li>Can be Used with Probabilities to Compute Certainty Equivalents (CEQ) </li></ul></ul><ul><li>A Number of Practical Approaches for Measuring Risk Tolerance are Available </li></ul><ul><ul><li>Industry-specific Questionnaires </li></ul></ul><ul><ul><li>Analysis of Prior Decisions </li></ul></ul><ul><ul><li>Industry Empirical Analysis </li></ul></ul>
46. SSG Utility Function Worksheet <ul><li>Make Participation Choices Among a Set of Exploration Prospects as Part of Your Annual Budget Process </li></ul><ul><li>Prospect Outcome Value Prob. Choice (W.I. Level) </li></ul><ul><ul><li>1 Success $75mm 0.50 100% 75% 50% 25% 0% Dry Hole -$30mm 0.50 </li></ul></ul><ul><ul><li>2 Success $45mm 0.15 100% 75% 50% 25% 0% </li></ul></ul><ul><ul><ul><li>Dry Hole -$3mm 0.85 </li></ul></ul></ul><ul><ul><li>3 Success $22mm 0.30 100% 75% 50% 25% 0% </li></ul></ul><ul><ul><ul><li>Dry Hole -$4mm 0.70 </li></ul></ul></ul><ul><ul><li>4 Success $16mm 0.80 100% 75% 50% 25% 0% </li></ul></ul><ul><ul><ul><li>Dry Hole -$9mm 0.20 </li></ul></ul></ul><ul><ul><li>5 Success $16mm 0.20 100% 75% 50% 25% 0% </li></ul></ul><ul><ul><ul><li>Dry Hole -$1.4mm 0.80 </li></ul></ul></ul>
47. RT & Analysis of Past Decisions <ul><li>Proposition: Analysis of Recent Resource Allocation Decisions Represents Firm’s Exhibited Risk Tolerance Level. </li></ul><ul><li>Study: </li></ul><ul><ul><li> Offshore Bid Sale </li></ul></ul><ul><ul><li>Firm: BP Exploration, Inc. </li></ul></ul><ul><ul><li>Prospects: 60 Offshore Drilling Blocks </li></ul></ul><ul><ul><li>Decisions: Bid on 48 Blocks (8 at 100%) </li></ul></ul><ul><ul><li>Note: All Blocks Had Positive Expected NPV’s. </li></ul></ul><ul><li>Findings: BP exhibited a risk tolerance (RT) level of between $30-$40 million. Firm maintained “consistent” risk attitude on about 50% of prospect decisions. Suggests firm was either highly inconsistent in its risk preferences or that other considerations influenced the bids. </li></ul>
48. Risk Tolerance & Financial Measures <ul><li>Howard (1988) suggest that the firm’s RT (1/c) can be closely related to financial measures such as sales, net income and equity. </li></ul><ul><li>Cursory study of oil and chemicals industry: </li></ul><ul><ul><li>Risk Tolerance/Sales 0.064 </li></ul></ul><ul><ul><li>Risk Tolerance/Net Income 1.240 </li></ul></ul><ul><ul><li>Risk Tolerance/Equity 0.157 </li></ul></ul>
49. Risk Tolerance (RT) And Firm Performance <ul><li>There Exists an Abundance of Evidence that Firms Behave in a Risk-Averse Manner. </li></ul><ul><li>From a Business Policy Perspective We are Compelled to Ask: </li></ul><ul><ul><li>What is the appropriate risk tolerance level for the firm? </li></ul></ul><ul><ul><li>What effect, if any, does corporate risk policy have on firm performance? </li></ul></ul><ul><li>Empirical Setting and Analysis </li></ul><ul><ul><li>66 of the Largest U.S. Based Oil & Gas Firms </li></ul></ul><ul><ul><li>Period of Investigation: 1981-1990 </li></ul></ul><ul><ul><li>Risk Tolerance Model Development includes domestic/foreign budget allocations, leasehold, exploratory and development costs, success rates, reserve additions, etc. </li></ul></ul>
51. Risk Tolerance versus Firm Size <ul><li>For the entire period 1983-1990, there exists a significant positive relationship between corporate risk tolerance and firm size. </li></ul>7.6 8.0 8.4 8.8 9.2 9.6 10.0 10.4 10.8 Log (RT) vs. Log (SMCF) Log (RT) Year: 1983-1990 8.6 8.2 7.8 7.4 7.0 6.6 6.2 5.8 5.4 Regression Line Log (SMCF) Observed Data
52. Risk Tolerance - Comparing Firms <ul><li>Risk Tolerance Ratio (RTR) - A New Approach for Comparing Risk Tolerance Among Firms of Different Size. </li></ul><ul><li>RTR = RT i /RT’, where </li></ul><ul><ul><li>RT i is the Observed Risk Tolerance for Firm i in Period t and RT’ represents the Predicted Risk Tolerance of Firm i as a Function of Size. </li></ul></ul><ul><li>RTR Provides Valuable Insight Concerning Competitor’s Relative Propensity to Take on Risk. </li></ul><ul><li>RTR Provides Guidance on Setting and Communicating an Appropriate Risk Policy . </li></ul>
53. Risk Tolerance Ratio <ul><li> Firm X Firm Y Firm Z </li></ul><ul><li>SMCF (Size) $1000MM $100MM $10MM </li></ul><ul><li>RT’ (Predicted) $ 100MM $ 15MM $ 2MM </li></ul><ul><li>RTi (Actual) $ 50MM $ 20MM $ 2MM </li></ul><ul><li>RTR (RTi/RT’) 0.50 1.33 1.0 </li></ul><ul><li>RTR>1.0 (<1.0) Implies a Stronger (Weaker) Propensity to Take on Risk Than Firms of Equivalent Size. </li></ul>
55. RTR - The Performance Implications <ul><li>RETURN ON E&P ASSETS </li></ul><ul><li>Risk Tolerance Ratio </li></ul><ul><li>High Moderate Average Low </li></ul><ul><li>(>2.5) (1.5 - 2.5) (0.5-1.5) (<0.5) </li></ul><ul><li>Mean 5.0% 9.1% 5.7% 5.3% </li></ul><ul><li>Stand. Dev. 2.5% 6.4% 5.0% 3.1% </li></ul><ul><li>Conf. Int. 3.3-6.9 8.1-10.7 5.6-7.7 3.8-7.2 </li></ul><ul><li>E&P Firms Exhibiting Moderate Risk Tolerance </li></ul><ul><li>Demonstrate Significantly Higher Returns </li></ul><ul><li>than Firms Either More or Less Risk Tolerant. </li></ul>
56. Summary of Concepts Regarding the Estimation of a Risk Attitude <ul><li>Makes explicit a corporate attitude toward risk taking </li></ul><ul><li>Can assure a constant risk attitude in different divisions/regions of a company </li></ul><ul><li>May allow comparisons with the risk attitudes of other companies in the same industry </li></ul><ul><li>Can be used to rank prospects, to determine shares, and to select the “best” portfolio from efficient ones </li></ul>
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