The following chapter outline's some of the literature and scholar works about risk tolerance, decision theory and financial performance of the firms. This research aims to find out the relationship between risk tolerance and firm performance of the Australian exploration and production companies, considering some other control variable; thus the literature review chapter is mainly divided in to three separate but related fields. First field to be reviewed is the works on the topic of risk tolerance and firm performance; these are the works that include both topic and have examined their relation in previous literature, in general or in a specific industry. The second field is on decision analysis theory and risk tolerance works, in order to get better understanding of risk patterns and indicators that are more frequently being used. Third field of literature review is on financial performance measurement techniques in different industries, especially in E&P sector.
Generally all mentioned topics have been in scholar's attention for many decades and there are numerous studies on some of the topics. All this is to come up with adequate understanding of what has been done in this field so that the result of this study would be relevant and practical to the industry. There are few works that shape the back bone of this research in the field of risk and performance, so it is considered by deriving the best out of each of the works and support of the all other chosen works we can get to a good conclusion for identifying best method mainly in terms of forming up appropriate hypothesis and arguments, right variables and best analysis techniques and most importantly compare the results with other researchers findings.
Generally there have been many studies in this field of examining risk and return - namely performance- which is the very back bone of financial most well-known theories such as Capital asset Pricing Model (CAPM) which was first introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, with different conditions and assumptions. There is also high number of high-end point works of researchers in the field of risk management.
Risk Tolerance and Performance
This sub-chapter is to review works on risk tolerance and it's relation to firm performance in oil and gas as well as other industries by high grade scholars. The first two works are reviewed separately as they shape the very backbone of this research in essence of the whole research model.
TESTING A CASUAL MODEL OF CORPORATE RISK TOLERANCE AND PERFORMNCE (Bromiley, 1991)
This article is based on the work of P. Bromiley, addressing how past performance and other factors influence risk taking as well as how risk taking and other factors influence future performance. This work is chosen as first review because the main part of this work reviews most of the famous and basic researches in terms of risk and return and general theories and based on them establishes a new hypothetical frame work for risk and performance relation.
This study is important in essence that is the first large-scale quantitative test for behavioral theory of the firm that was first stated by Cyert and March (1963), and the statistically analyzed data outcomes builds a theoretical framework of risk taking that is more complex than past works. Talking about risk and return expectations the famous works of Bowman (1980, 1982, 1984) and what he described as risk - return paradox. Since (Bowman E. H., 1980) many studies have investigated risk-return correlations, and accoridng to (Bromiley, 1991) many studies found possitive and negative associations between return and variance in retunr [known as risk]. Author state's that the problem with much of the past works is that they all have tried to make a casual statement about risk and return in the situation of dealing with strictly cross-sectional data. This reasearch tries to address these two main issues:
Determinants of corporate risk taking
Effects of this risk taking on future economic performance of the firm, in order to find the answer to bid issues author advances risk research by
Presenting and estimating a dynamic model based on the theory of organizations
Looking for possible ties between risk taking and future economic perfomance
Using an x-ante measure of risk taking
Model is developed based on the behavioral theory, which includes five basic variables: performance, slack, aspiration, expectations, and risk. These variables are determinants risk taking in a firm and this hypethese is being tested. After estimating the positive and negative effects of determinants on Risk according to past literature, author builds a model for testing performance and found out the determinants of performance, the considered determinants of performance are as follow: risk taking, aspirations, expectations, slack, future average industry performance, and past performance. According to the past literature change and risk taking in organization has a positive influence on future performance (Bromiley, 1991), this assumption is so important in terms of which this matter is not significant, because on the other hand there are handful of literature with contradicting results. Moving to measurement techniques, risk is being measured as an ex ante uncertainty of a firm's earning stream. Such as the variance of return on assets (ROA), in terms of performance measurement, between several variables as, ROA [1] , ROE [2] , ROS [3] , first variable is chosen. And another important variable is Expectations that is measured by means of earning forecasts produced by securities analysts. To measure aspirations author combines firm's past performance and average industry performance. Slack is divided to three categories of available, recoverable, and potential slack [4] . As a relatively old research and considering internet not being advanced as it is right now the data collection is from SCI [5] and COMPUSTAT [6] tapes sources and also IBES [7] . Data collection period is from 1976 to 1987, for 11 years. And sample size and description is 288 listed manufacturing companies in America.
As the results, according to formulations and data available after statistical data analysis (means, standard deviation, correlations, least-square approach), consistent to study hypothesis and former literature, performance has a significant negative influence on risk taking. For better summarizing the results and comparisons a descriptive table of correlations and methods provided by me as per below.
List of equations developed by (Bromiley, 1991):
Riskt+1 = b0 + b1 performancet + b2 industry performancet + b3 expectationst+ b4 aspirationst + b5 slackt + b6 slackt2 + risk, + e,
Performancet+2 = C0 + C1 performancet+1 + C2 industry performancet+2 + C3 expectationst+ 1+ C4 aspirationst+ 1 + C5 slackt+1 + C6 slack2t+1 + C7 riskt+1+ e,
Table : Descriptive results and correlations based on Bromiley (1991) findings
Risk taking
Future Performance
Correlation
Consistency/Contrary
With hypothesizes
Correlation
Consistency/Contrary
With hypothesizes
Performance
Sig. Neg.*
Consistent
Insignificant
-
Past industry performance
Sig. Neg.
Consistent
Sig. Positive
Consistent
Expectations
Positive
Contrary
Sig. Neg.
Consistent
Aspirations
Sig. Positive
Consistent
Sig. Positive
Consistent
Previous risk
Sig. Positive
Consistent
Sig. Neg.
Contrary
Slack
Nonlinear Pos. correlation
Consistent
Nonlinear Pos. correlation
Consistent
* Significant Negative
Risk reduces future performance
Aspiration have positive and expectations negative influence on performance
Slack in available and potential form increases performance
Reviewing results only in terms of risk and performance, author shows that performance has negative influence on risk taking and risk taking impacts subsequent performance negatively. The result also shows a loop order for the relation of risk and performance in year after year.
In further investigations from author shows that the magnitude of negative influence of risk on performance in very next year is less than influence of risk on performance, four years later. Generally comparing results with what from literature, estimation results strongly supports risk model, except the positive influence of expectations on risk taking.
The overall findings for this article is a dynamic model of risk and performance with examining the determinant variables, but authors aim to show it is not simple to make a casual statement about risk-return correlation is successfully met; findings show several factors limiting generality of study such as: large scale manufacturing companies, measuring risk with income stream uncertainty and etc. Herewith we finish the review of the first article by considering the results and methodology as a good and high grade reference for present study.
CORPORATE RISK-TAKING AND PERFROMANCE: A 20 YEAR LOOK AT THE PETROLEUM INDUSTRY by Micheal R. Walls- 2005
This study is being conducted based on a former study by same author in year 1996, with a similar title, by introducing a new implied measure for risk tolerance. Following what has been done this study also pursues the same similar methodology with some upgrades here and there. These upgrades and detailed attentions are more in terms of higher sample size and duration as well as a much better writing of the article and elaborating the new concepts and aspects that has been developed and experimented. Also this study is the backbone of present research and I have also used similar approach for measuring some terms with entering more variables and several experimented techniques from other authors to examine and compare the results and come up with the most suitable model for risk tolerance and firm performance of corporates. This research is based on empirical work over 50 United States- based largest firms during 20 year period from 1981-2002. In this research author aims to implement the expected utility theory [8] in a corporate setting in order to provoke manager's risk preferences as an agent for the firm utility expectations. The chosen utility function for this research is the common and dominant form of as, u(x) = -e-x/R [9]
The second important parameter used in this research as a measure of preference theory is certainty equivalent [10] 'which in the case of exponential utility function is the firm's buying price or minimum selling price for a given risky investment'
Formula for discrete probability distributions: [11] Considering the above equation being so complicated in state of many projects in a firm, author has used the finding of another research to simple size the calculations in the case of normal distribution of investment returns, and an exponential utility function, has shown that certainty equivalent is equal to
The primary data is collected from the data base of SEC [12] . In order to get a better view of what decision makers anticipated from a project, the mean values from several years of activity is being used in this work that is consistent with the goal to build a risk policy in time decisions. Exploratory success rates are equal to number of exploratory well success divided by number of which were drilled. NPV [13] per BOE is used to represent a measure of value of the project per reserve added to the firm including all costs of the project. In order to consider the ex-ante modeling procedure, an adjusted measure of 3 years average NPV divided by number of exploratory projects (wells) is implemented. Results show that, in terms of risk tolerance unit in regions, as domestic or international wells there exists a significant difference between domestic and international risk tolerance per projects.
A controlling variable, firm size is included which is an indicator of firm's wealth. An appropriate measure of firm size for oil companies is SMCF [14] . This data is also collected from 10-k fillings required from SEC. There is significant positive relation between firm size variable and corporate risk tolerance (RT). A new RTR [15] measure is constructed in order to take effect of the firm size in accordance to firm's risk tolerance. The RTR measure is a relative measure of firm's risk tolerance to other firms in the industry. Considering the aim of the research in next section author goes through examining the company's coherency of its risk policy in relation to firm's performance, which in this work is measured by ROA [16] variable that is good and consistent indicator in this case. To better investigate the relation and for the purpose of more meaning full results, companies got divided in to four groups according to their RTR, in to, high, moderate, average and low risk preferences. Then by using an ANOVA statistical test the result came to surface that, there exists a significant difference between E&P performance as it relates to risk taking. "Firms with high risk tolerance levels demonstrate significantly higher returns".
Generally, willingness to take risk is highly related to the returns on investments made. However contrary to this argument, the study by Y.H. Venus Lun , Michael Browne, Kee-hung Lai, Christina W.Y. Wong , T.C.E. Cheng on the container terminal industry (2011) finds no direct correlation of firm's better performance and higher return and its appetite for business risk-taking by container terminal operators. Instead, findings suggest that the scale of operations is directly related to business risk-taking that is larger scale of operations are willing to take more business risk.
Authors propose three hypotheses which are tested with the help of a correlation matrix on an empirical data covering terminal turnover, earnings, throughput, operating cost, and risk rating from Drewry (2007).
The outcome of the tests suggests that that business risk-taking is not associated with profitability and efficiency which are measures of firm performance. The scale of operations is measured by terminal turnover and terminal throughput in the container industry and there exists a strong relationship between scale of operations and business risk-taking. Results of the study also present contrarian view that claims of the "death of beta", and states that there is not relation between risk and return.
1.2.3 RISK ANALYSIS APPLIED TO PETROLEUM EXPLORATION AND-2004
In this paper, author presents an overview of the main contributions in risk analysis for petroleum exploration and production encompassing brief review of previous applications involving the risk analysis in petroleum exploration, field appraisal, development and production forecast under uncertainty and the decision making process.Along with some of the main trends and challenges, methodologies that affect the present level of risk applications in the petroleum industry aimed at improving the decision-making process are discussed.
While discussing risk analysis in petroleum exploration, the author goes through evolution of the entire technique tracing back from 17th and 18th century from mathematical studies of probabilities to lognormal risk resources distribution (Attanasi and Drew, 1985), Pareto distribution applied to petroleum field-size data in a play (Crovelli, 1995) and (3) fractal normal percentage (Crovelli et al., 1997). He also studies the paper by Walls (1995) which is an important contribution that provides rich insight into the effects of integrating corporate objectives and risk policy into the investment choices for large oil and gas companies using the multi-attribute utility methodology (MAUT). This theory was applied by Walls and Dyer (1996) to investigate changes in corporate risk propensity with respect to changes in firm size in the petroleum industry. Later, MAUT models were applied by Nepomuceno et al. (1999) and Suslick and Furtado (2001) to measure technological progress, environmental constraints as well as the financial performance associated with exploration and production projects located in deep waters. Several contributions devise petroleum explorations consisting of a series of investment decisions on whether to acquire additional technical data or additional petroleum assets (Rose, 1987). Changing corporate and industry environment and huge contribution generated by the technological development in E&P makes it necessary to monitor firm's level of risk aversion on a continued basis (Rose 2000).
Major uncertainties at exploration stage relate to volumes in place and economics. Access and availability of greater information helps mitigate uncertainties. Hence quantifying risk alone is not sufficient. It has become absolutely necessary adopt modern techniques that are pointing to quantification of value of information(VoI) and flexibility (VoF), optimization of production under uncertainty, mitigation of risk and treatment of risk as opportunity. Robust methodologies developed to quantify VoI and VoF have made the decision to invest in information or flexibility easier. Finally, the author concludes that despite limitations and difficulties, risk analysis provides a means for handling highly complex decisions characterized by multiple objectives and high degrees of uncertainty in diverse stages of petroleum upstream. It also provides an approach for dealing with complex value tradeoff and preferences of the stakeholders in the decision process in oil exploration and production. It is a systematic and comprehensive way for considering all relevant factors in a decision in the E&P process.
Examining the influence of firm performance on business risk-taking _ in the container terminal industry-2011
Generally, willingness to take risk is highly related to the returns on investments made. However contrary to this argument that discussed in Walls theory, the study by Y.H. Venus Lun , Michael Browne, Kee-hung Lai, Christina W.Y. Wong , T.C.E. Cheng on the container terminal industry (2011) finds no direct correlation of firm's better performance and higher return and its appetite for business risk-taking by container terminal operators. Instead, findings suggest that the scale of operations is directly related to business risk-taking that is larger scale of operations are willing to take more business risk. Authors propose three hypotheses which are tested with the help of a correlation matrix on an empirical data covering terminal turnover, earnings, throughput, operating cost, and risk rating from Drewry (2007). The outcome of the tests suggests that that business risk-taking is not associated with profitability and efficiency which are measures of firm performance. The scale of operations is measured by terminal turnover and terminal throughput in the container industry and there exists a strong relationship between scale of operations and business risk-taking. Results of the study also present contrarian view that claims of the "death of beta", and states that there is not relation between risk and return.
Efficient container terminal operators aim at minimizing inputs while maximizing outputs for high operating efficiency. Investment is associated with business risk-taking and return on investment is dependent on sales growth.
Risk tolerance and decision theory
DECISION ANALYSIS: PRACTICE AND PROMISE by Ronald A. Howard - 1988
Decision analysis has been a subject of research for over hundreds of years and has evolved to great dimensions. In this paper Howard lays down all the decision making methods that make difficult and highly challenging problems clear and easily understandable.
Howard explains the decision making process in three steps - formulating a decision basis, evaluation by a primarily computational process to arrive at alternatives that is consistent with the basis, appraisal of the alternatives that may reveal some shortcomings of the analysis and may require refinement to ensure that it is truly appropriate to the problem. The three parts of basis and tools that help decision making are discussed in detail.
The paper discusses procedures for formulating, evaluating and appraising the decision problem like strategy generation tables, decision quality concepts, influence diagrams, clarity tests, direct indirect values that explain preferences, generic risk attitude considerations that help relating corporate risk tolerance to the financial measures of the corporation, spreadsheet, decision tree, and influence diagram programs that help expedite evaluation and computer aided intelligent decision systems provide benefits of decision analysis on broader scale.
In this paper he tries to reason why decision analysis is not routinely applied to important decisions. He believes the study of human nature, concept, scope, skill, and efficiency may help arrive at a reason.
He establishes the fact that the discipline of decision analysis can provide persuasive clarity to those few who have the resources and the will to use it. He also states that the challenge is to provide this help at an affordable price to all who could benefit from it.
MEASURING AND UTILIZING CORPORATE RISK TOLERANCE TO IMPROVE INVESTMENT DECISION MAKING by Michael R. Walls
Corporate tolerance to financial risks plays an important role in improving the quality of investment decision-making under uncertainty. Walls findings imply that generally managers are risk averse but struggle of being consistent in taking financial risk-taking investment decision. Risk tolerance assessment taken in his study helped the corporate to form risk policy. Managers make choices among risky alternatives based on preference theory which is individual in nature and can be measured through Certainty Equivalent by assigning certain value for an uncertain event. The value can also be assigned in the form of probabilities. This then forms the base of decision making. Walls also adopted a survey based approach to give a realistic basis. It helped to make reasonable estimate an implied risk tolerance for each of respondents. Also it highlights that complex set of investment opportunities can lead to inconsistencies in individual decisions. Economic decision analysis techniques are designed to improve that part of decision making process. Also the survey highlights that the differences in risk tolerance by group is relatively small helping firm to bring consensus on setting acceptable risk tolerance value and policy. Corporate risk tolerance changes over time as per firms size and capital structure/ Also Walls approach helps manager to openly discuss risk and risk tolerance issues and better understand its effect on decision making and corporate strategy. The earlier work of Walls "Propensity and Firm Performance (1995)" studied how risk propensity is linked to firm's size and performance. Series of interviews with middle and senior level managers from 26 petroleum exploration firms over a three-year period motivated the study. The research was based on sample of 55 petroleum exploration companies during the period of 1983 - 1990 by measuring each firm's risk propensity in the form of an "implied" utility function year by year. Walls differentiated between the concepts of ex ante risk {risk tolerance) andex post risk {variance and ordinal measures) and separately analyzed the information embedded in each of these distinct measures. The key strength of this study lies in the fact that it is based on actual decision and not hypothetical situations. Archival data representing actual resource commitments by petroleum exploration firms under conditions of risk and uncertainty are examined. However, the risky alternatives considered in the study are based on approximations of the ex ante risk perception of the decision makers.
A measure of ex ante risk that conforms to the manner in which managers conceptualize the notion of risk is introduced by Walls. By differentiating between the concepts of ex ante risk {risk tolerance) and ex post risk {variance and ordinal measures), the information embedded is much better there is clear this work separately analyzes the information embedded in each of these distinct measures.
Finally the results indicated that consistently across firms, there exists a positive relationship between corporate risk tolerance and the size of the firm consistent with Howard's (1988) argument that the ratio of corporate risk tolerance to certain financial measures is equal to a constant.
EXAMINING RISK TOLERANCE IN PROJECT-DRIVEN ORGANIZATION by Young Hoon Kwaka, Kenneth Scott LaPlace-2004
In this paper the importance of risk and risk tolerance has been re-iterated in the context of a project driven environment. Issues involving risk are often difficult to identify and interpret by those making crucial decisions for firms and projects. Perception of risk varies in a particular project based on its characteristics and internal and external environment. Hence, there is huge importance on defining "risk" and "risk tolerance" as it directly related to project management in a technology-driven organization. The authors have defined and modeled risk tolerance and assessed it from perspectives of a firm, project manager, and stakeholder.
"Risk tolerance concerns both the probabilities of inherent risk occurrences taking place and the resulting impact of those occurrences." The authors developed tools and techniques to display these components for each risk and analysed and examined firm's risk tolerance against them. The utility curve is another tool used for understanding risk tolerance.
Finally the authors believe that in order to avoid hazards of deficient risk tolerance analysis an explicit risk management plan should be laid identifying risk tolerance levels, firm should review its compensation policies for project managers and other employees and imbibe a culture that supports proper risk-taking and innovation. And lastly, comprehensive performance reviews of project managers also aid in maintaining a common understanding and vision of risk tolerance among the firm and the employees.
Risk tolerance is a crucial part of any risk management plan. It is the most crucial part of decision making process. However, risk tolerance cannot be analyzed at the beginning of a project and ignored later as risks keep changing at every level with changing scenarios. Risk tolerance is however gaining importance ensuring the integrity of valuable and potentially innovative projects.
P&R#1- macmillan-2000-good sample (2 page max, objective, utilized theory in this work, sampling and results are more important)
1.3.4 SOME DETERMINANTS OF CORPORATE RISK AVERSION by J. Eric Bickel - 2006
(objective, sampling, model, results with special focus on corp risk aversion determinants and factors and reason for that) ]
Author roughly quantifies the degree of risk aversion induced by three rationales for corporate risk management: the cost of financial distress, costly external finance, and the principal-agent relationship between shareholders and management.
Performance measurement and firm size
INDICATORS OF SUCCESSFUL COMPANIES by Robert Johnson and Luc Soenen
This paper examines factors distinguishing financially successful from less successful companies using monthly Compustat data for 478 companies covering the period seventeen years (1982-1998). Authors used three different methods, i.e., the Sharpe ratio, Jensen's alpha, and EVA to and measure and evaluate financial success. A total of 10 indicators of superior performance were considered for the study - Book to market ratio, size, sustainable growth, profitabily, capital structure, liquidity, cash conversion cycle and other success indicators.
In the paper, success is defined as doing better than the average Sharpe ratio, Jensen's alpha, and EVA relative to total assets for all sample firms. The results indicated Capital structure, liquidity and earnings volatility did provide an indication of firm success. However, especially large, profitable companies with efficient working capital management and certain degree of uniqueness are most successful.
Authors introduced a binary logit model for predicting whether each measure of firm performance beats the average value for the firms in the sample. The model indicated that the 10 indicators of successful companies considered for the study exhibited strong predictive power.
P&R#3- Modeling the relationship between ï¬nancial indicators and company performance (more about the performance measuring variables and techniques, sampling and results )
MODELING THE RELATIONSHIP BETWEEN FINANCIAL INDICATORS AND COMPANY PERFORMANCE by Mag. Lukas L. Höbarth
This research is based on empirical study on US-listed companies over a 19 year time period intends to find some of these key factors and model a relationship between these indicators and company performance. In his paper, the author defines and analyses 17 potential indicators based on previous studies and partly based on the author's own considerations. He takes a three dimensional approach where both internal and external success id measured by taking into account profitability measure and cash flow measure in addition to defining financial success as market value (current stock price) or as a market related measure (e.g. Sharpe's ratio).
For the purpose of the study author uses methods which can be calculated easily without needing too much sideline information.
P&R#5- A framework for combining riskmanagement and performance-based building approach-2010 (review like before with special attention to performance var's)
P&R#6- RELATIONSHIPS AMONG RISK, INCENTIVE PAY, AND ORGANIZATIONAL PERFORMANCE-1998 (focus on performance measure)
Firmsize and the gains from acquisitions (like before, main focus on firm size measurement and utilized variable) ]
