The Ecology of Risk Taking

47 Pages Posted: 22 Jan 2003

See all articles by Francois Degeorge

Francois Degeorge

University of Lugano - Faculty of Economics; Swiss Finance Institute; European Corporate Governance Institute (ECGI)

Boaz Moselle

Ofgem

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: October 10, 2002

Abstract

We analyze the risk level chosen by agents that have private information regarding their quality. We show that even risk-neutral agents will choose risk strategically to enhance their reputation in the market, in a manner determined by the risk choices of other agents.

Our model employs the following sequence: (1) an agent learns his type, which determines the opportunity locus relating risk and expected payoff; (2) the agent selects a level of risk; (3) a period payoff is reaped; (4) the market draws inferences from the period payoff; and (5) the agent receives a reward that is positively related both to his period payoff and to his reputation.

We analyze separately the cases of observable and unobservable choice of risk. When the choice of risk level cannot be observed, good agents will choose low levels of risk, and bad agents high levels, provided the market has no strong prior about whether agents are good or bad. Good agents are seeking to reduce noise so as to stand out; bad agents are seeking to increase noise in the hope of producing the results of good agents. When the choice of risk level is observable, pooling behavior is to be expected: Agents of different qualities choose identical, low levels of risk.

Empirical evidence is gathered on 2462 firms over 24 years. In the corporate context, risk choices are likely to have a significant unobservable component. As conjectured, the evidence rejects the model where risk choice is observable and bad firms thus mimic good firms. Our results support the unobservable risk choice model, and its prediction that agents of higher quality will have less variable performance.

Keywords: Risk Asymmetric Information

JEL Classification: D81, D82

Suggested Citation

Degeorge, Francois and Moselle, Boaz and Zeckhauser, Richard J., The Ecology of Risk Taking (October 10, 2002). Available at SSRN: https://ssrn.com/abstract=363100 or http://dx.doi.org/10.2139/ssrn.363100

Francois Degeorge (Contact Author)

University of Lugano - Faculty of Economics ( email )

via Giuseppe Buffi 13
CH-6904 Lugano
Switzerland
41 58 666 4634 (Phone)
41 58 666 4647 (Fax)

Swiss Finance Institute

c/o University of Geneva
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Switzerland

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Boaz Moselle

Ofgem ( email )

9, Millbank
London SW1P 3GE
United Kingdom

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-384-9340 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-496-3783 (Fax)

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