Measures of firm risk-taking: revisiting Bowman’s paradox

Abstract

Purpose The purpose of this paper is to contribute to the existing literature on the relationship between firm-level risk and returns and to explore other ways of measuring firm risk-taking. Literature overwhelmingly shows a negative relationship between firm-level risk and returns based on accounting data, which is counter-intuitive from the rational perspective of risk-aversion. This paper revisits this so-called Bowman’s paradox by examining the wealth of literature on the topic and empirically tests alternative measures of firm risk-taking that could provide a counter-argument on the existence of the paradox. Design/methodology/approach After formulating the criteria for such a measure, potential measures of firm risk-taking were developed based on variability of some key financial ratios and empirically tested using US listed companies’ data for several time periods from 1992 to 2016. Literature has explored the use of these financial ratios (e.g. R&D expenses as percentage of sales) based only on their magnitude. This paper is novel in that it examines the variability and not just the magnitude of these parameters. Findings Results showed the same counter-intuitive negative relationship between firm risk-taking and returns but the paper was able to identify an area for future theory development that hopefully will lead to a firm risk-taking measure that would exhibit the elusive positive relationship with returns. Originality/value The literature review of this paper brought together and provided a succinct classification of the various explanations for Bowman’s paradox that allowed the identification of a potentially rich area of research. It identified a gap in the literature which is the formulation of suitable measures of firm risk-taking and made investigations in this area.

The relationship between managerial attributes and firm risk-taking

“…organizational risk). This distinguishes the proposed measure from the widely used risk measure of the variability of returns based on the results of managers' actions (Santacruz, 2020). In this study, following Erkens et al (2012) and Imhof and Seavey (2014), firm risk-taking is calculated as the SD of stock return in the sample years, and the greater the volatility of stock returns (SD), the greater the firm risk-taking and vice versa.…”

“…managerial risk-taking) or outcomes (i.e. organizational risk) (Santacruz, 2020). There is no explicit distinction between managerial risk-taking and corporate risk.…”

Does prospect theory explain Bowman's paradox in Asian emerging markets?

“…Another important dimension of the risk-return association is the proxies used for calculation of risk. The nature of firm risk is very complex and dynamic phenomena (Santacruz, 2020). That is why, it is very difficult to operationalize it for academic research.…”

Is it attractive to invest in alternative energy? Evidence from a five-factor Fama-French model for regional DJSI and renewable stock indexes

“…These authors opt to use other models such as the three-factor model of Fama and French (1992), which posits that the expected return depends on the systematic risk, company size and the value effect. However, owing to its inconclusive results (Bowman, 1980;Fiegenbaum and Thomas, 1988;Henkel, 2009;Santacruz, 2019), the three-factor model has been improved with the addition of new variables. The result is Carhart's (1997) four-factor model which adds the momentum factor Winner minus Loser (WML), or Fama and French's (2015) five-factor model which incorporates the Robust minus Weak (RMW) and Conservatives minus Aggressive (CMA) factors.…”