Corporate risk management and mitigation strategies

¶ … solely my own work and creation and it has been prepared solely for credit in this class.

Sullivan, Kathryn (1997). Corporate Managers' Risky Behavior: Risk Taking or Avoiding? Journal of Financial and Strategic Decisions. Vol. 10, No. 3. Retrieved from http://www.studyfinance.com/jfsd/pdffiles/v10n3/sullivan.pdf.

The article that will be reviewed in the following pages focuses on discussing the risk behavior that is revealed by certain studies on professional corporate managers, in general. A more particular issue addressed by the article consists in analyzing whether these managers take risks or avoid taking risks when making decisions that include financial information and whether this kind of information influences managers' risky behavior.

One of the things that I find very useful for drawing correct conclusions regarding the article's topic is the fact that the author used the Prospect Theory, developed by Kahneman and Tversky. The Prospect Theory states that individuals involved in the decision making process use a reference point that has different significance to them and classify decision alternatives as gains or losses in relation to that reference point. In other words, the outcomes above the reference point are considered to be gains, while outcomes below the reference point are considered to be losses. The prospect theory further states that, regarding risk management, decision makers will generally avoid risks when selecting between alternatives that qualify above the reference point, and that they will choose to take risks when dealing with alternatives that qualify below the reference point. I strongly support this theory and I find that the applications of this theory in practice can be very useful for individuals that are found in the situation of making decisions, and for individuals that analyze the behavior of individuals involved in risk management and decision making processes.

The article gives certain examples of this theory. I find these examples perfectly suited to the issue, and very clear, even for those who do not have important knowledge on decision making on risk management. The article also reveals the fact that the prospect theory and the so-called concept of mental accounts indicate the fact that the manner in which managers choose to code their financial information influences their risky behavior. A mental account consists in the fact that "a decision maker may combine different types of information considered relevant to a given decision in one mental account, and assign other information considered irrelevant to the task to other mental accounts" (Sullivan, 1997).

Given the fact that the above mentioned issues have only been analyzed in theory, the article further displays the results of several experiments that study managers' risky behavior. I think it is very important to back up any theoretical findings with examples from real practice. Theories, no matter what field they apply to, do not hold much value unless they are supported actual data and verified information.

In this case, in order to verify the theories discussed above, five experiments were performed on 72 corporate financial managers with significant experience in the field. The following experiments were conducted: framing, profits and losses, profits and expenditures, revenues and costs, profits and costs.

The main purpose of all these experiments was to analyze these managers' risk taking behavior when dealing with different forms of financial data. The experiments consisted in choosing between two competing capital investment alternatives. One of the alternatives represented a risky option, while the other alternative represented a certain or a less risky option. The managers subjected to the experiment were supposed to select one of the alternatives and to rate it on a five point preference scale.

The first experiment was the Framing, and was based on the classic lives saved, lives lost scenario, proposed by Tversky and Kahneman. In this experiment, one group of managers was exposed to the gain, or save frame, and the other group was exposed to the loss frame. The economic conditions of the experiment consisted in expected loss of $600,000 for the next quarter. In this case, the results revealed that the framing effects supported the Prospect Theory. Also, it seems that "artificially changing the frame of the decision problem resulted in a change in the financial managers' decisions, even though the alternatives were essentially identical in both groups. Risk avoiding tendencies were observed when alternatives were framed as gains, while risk taking occurred when managers were required to choose between alternatives that involved financial losses" (Sullivan, 1997).

The other experiments presented similar results. All these experiments indicated that corporate managers tend to avoid taking risks when making decisions. The study also concluded that managers will generally tend to avoid taking risks in most financial contexts and conditions, different from the ones presented in the study.