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Moral and systematic risk: A rationale for unfair business practice
33
MORAL AND SYSTEMATIC RISK: A RATIONALE FOR UNFAIR BUSINESS PRACTICE
Dale 0. Cloningeri
Introduction
The objectives of this paper are (1) to distinguish moral risk (the risk associated with unfair business practice) from normal business (operating) risk and financial (default) risk; (2) to analyze the effect of moral risk on the systematic risk of a nonlevered asset; and (3) to discuss the rationale for businessbehavior which employs unfair (illegal) businesspractice. The discussion will show how the use of business practices that involve moral risk can decrease the unlevered, systematic risk of an asset. This finding contrasts with the naive notion that acceptance of moral risk would simply add to the risk associated with the operation of a nonlevered asset. The possibility of reducing business risk by the acceptance of smaller amounts of moral risk could provide a rationale for the use of certain unorthodox business practices. Moral Risk
Moral risk, as defined herein, is not unlike and indeed is a derivative of the concept of moral hazard as used in the field of insurance. In their principles text, Mehr and Cammack (7) defined moral hazard as the possibility that an individual will deliberately
‘Dale 0. Cloningct is a professor of finance and economics at the University of Hou,ston at Clear Lake City in Houston Texas.
34
bring about a loss for which the individual is insured. Moral risk is not confined to actions involving insured hazards, however. Moral risk is the risk of exposure, including arrest and conviction for illegitimate acts, of a wide range of activities involving illegal, immoral, unethical or even unfair practices. Examples would include arson, bribery, blackmail, cheating, corporate espionage, extortion, fraud, patent or copyright infringement, lying or gross misrepresentation, price fixing and counterfeiting among others. The possibility of exposure affects business risk associated with the asset through the effect exposure may have on the variability of anticipated cash flows. The moral2 risk of any action is manifested in the increased uncertainty of the possible returns, i.e., the increased variability of the expected returns of the assetsince cash flows may be affected by moral, legal or social sanctions. In a discussion of expected return, Polinsky and Shave11 (8) addressedthe issue of the determination of the optimal probability of arrest and fme (moral risk). The authors pointed out that under either an assumption of risk neutrality or risk aversion those individuals whose private gains exceeded the external costs of their activity would participate in the activity. The optimal probability of capture would be as low as possible for risk neutral individuals and one for individuals who are risk averse.The risk averse condition holds only if the costs of capture are sufficiently low. Experience indicates the actual probability of capture is quite low. This experience may indicate either a suboptimal probability of capture for risk averse individuals or, as suggestedby Polinsky and Shave& the cost of capture is sufficiently high to drop the
‘Use of the word moral in this context migbt appear inappropriate inasmuch as the actions could be considered immoral. The use of the word moral merely reflects the potential loss of moral standing as opposed to the commitment of immoral acts.
35 optimal probability to virtually zero. If the latter were the case, the optimal probability of capture would be low for both risk neutral and risk averse individuals. Near zero probability of capture can produce conditions in which the assumption of moral risk will result in disproportionately less business risk and hence less overall risk. This possibility is the subject of the remainder of this paper. Risk and Crime Aversion Business or operating risk refers, in the financial literature, to the variability of returns of cash flows. In a world of risk averse investors the market will only compensateinvestors for systematic (market) risk and not for unsystematic (random) risk that may be diversified away. The risk of an unlevered firm is a unique function of that firm’s correlation of returns with the market as a whole. An efficient market will force returns on securities to a level that is commensurate with the systematic risk identified by the covariance of returns. That is, an efficient market prevents expected returns in excess of that generally compensated by the market for the level of risk incurred. The possibility of using unfair/or illegitimate business practices together with the presence of moral and/or legal sanctions designed to prevent such practices could create opportunities which decision makers, if they were so inclined, could exploit. To do so, of course, would expose the decision makers and the asset’s expected returns to moral risk. The decision to utilize unfair practices would then depend on how the asset’s business risk is affected by these practices and the degree to which the decision makers are crime3 averse.
3Crime is used here as a catch-all term for all of those practices that produce moral risk whether they are specifically forbidden by law or not.
36 Crime aversion can be treated analogously to risk aversion. Decision makers can be characterized as either crime averse, crime neutral or crime prone. For the latter group, value maximizing conditions are not necessary and may be more than sufficient. They would, everything the same, choose that alternative for which the potential returns were the greatest regardlessof its fairness or legality. For crime neutral decision makers, value maximizing conditions are both necessary and sufficient before decisions to commit unfair or illegitimate acts will be made. Value maximizing conditions are necessary but may be insufficient for the crime averse to employ unfair practices. But like risk aversion, crime aversion may be overcome by the promise of sufficiently high returns or low risks. Like risk, a premium for the commission of unfair practices would be demanded and the size of that premium would be a direct function of the extent of the decision maker’s crime aversion. The scope of this paper does not permit a complete discussion of crime aversion. However, Block and Heineke (1) provide an insightful discussion into this issue. For the remainder of this paper decision makers will be assumed to be crime neutral. The Effect of Moral Risk on Systematic Risk Virtually all financial texts measure systematic risk, in a manner of Sharpe (8) and Litner (6), as the covariance between returns for any asset j and the market portfolio divided by the variance of returns for the market portfolio. The result is referred to as Beta and is defined as a measureof the responsivenessof the asset’s returns to those of the market portfolio. Symbolically, COV(j ,m) (1)
P = VAR(m)
37
The covariance may also be expressed as the product of the correlation coefficient ( Pjm) and the standard deviation of j and the standard deviation of m. Or,
P =
Pjrn’j’rn (2)
2 ‘rn
P =
pjm”j 3n
Where Pjm and Uj are the ‘fair’correlation coefficient and standard deviation of asset j respectively and urn the standard deviation of the market. If /3, is defined as the fair market measure of systematic risk and p, as the “unfair” market measure of systematic risk, then the theoretical relationship between them may be expressedby, 4
cov
u
o(I urn 8” = EOY
0
u u
”
.
80
0
au om COV
U
= cov
0
aa
om. -uu om
D
0
u. 0
80
mv”
with the relationship of ou and covu being indeterminate.
38
flu pu. % -=00 PO 00
or
(4)
’
5.l Pu
=“u PO
.
--PO
(5)
Oo
The objectives of unfair businesspractices can be assumed to be the same as fair businesspractices - maximization of return for any given level of risk and minimization of risk for any given level of return. From equation 5 it is clear that the effect of unfair business practice on systematic risk is manifested in the ratios of correlation coefficients and standard deviations of assetsdiffering only in the extent to which unfair businesspractices are employed in their operation. The coefficient of correlation between the asset and the market may or may not be affected by the firm’s efforts to reduce the asset’s systematic risk. That is, efforts to decrease the asset’s risk by reducing the variability of its returns do not necessarily result in a reduction of the asset’scorrelation with the market. In fact, a smaller standard deviation of returns is not inconsistent with either a smaller or larger correlation of returns. At the limit, of course, a zero standard deviation would also mean a zero correlation. If efforts to reduce the variability of returns affect the correlation of returns randomly with a mean of zero, then the correlation can be assumed to be independent of these efforts. That is, UP,)
= E(P,),
or
39 A PO = lo, + e, - e, where e, and eu are the error terms associatedwith the random variables p, and p, respectively. Then equation 5 becomes
P,=
4l + eu /r
4.l
. %l -PO
+
e,
-
e,
uO
If e, and eu are independent and e, is randomly distributed with a mean of zero, then
= 1, and
P,
%I =-00 OO
The supply of unfair business practices, which includes but is not limited to bribery, theft, arson, espionage and fraud, is assumed to be sufficient to allow management to protect any potential investment opportunity. Much like the possibility of abandonment places a floor below the returns associated with the operation of an asset, unfair business practices such as arson, as one form of abandonment, may do the same. That is, if the capitalized returns of the asset fall below the value of abandonment by arson or any other means, the asset is abandoned and future losses prevented. If the abandonment value were high enough any return less than the maximum potential would result in abandonment. The possibility of arson does not limit abandonment value to something equal to or less than the original purchase
40 price or even its current legitimate replacement value. Various schemes exist to raise arson abandonment value high enough to not only prevent any future loss but to cover any past losses as well. In a recent article, Cloninger (3) demonstrates how and under what conditions arson would be the maximizing form of abandonment. In a similar manner bribery and other unfair practices may allow management to guarantee contract approval, provide substandard performance, restrain competition and employ other actions which result in a modification of the distribution of potential returns. The modification could take the form of both higher expected value and a smaller standard deviation. In this fashion, this process of “hedging” of what otherwise may be a fair or legitimate project through the use of unfair and/or illegitimate business practices reduces the operating risk of the project. At the limit, the asset’soperating risk could be completely neutralized and its expected return maximized. The asset’sdistribution of returns would then take the form of a vertical line at its maximum potential return. Potentially the whole market could exploit the gains from hedging. If the impact were symmetric across all assets there would be no exploitable opportunities as a result of the hedging process. However, the market is unable to duplicate the extent of the gains from hedging becauseof the presenceof legal,.moral and ethical sanctions that exist to prohibit such behavior. Thus, decision makers who are successful in hedging an asset’sbusiness risk have an advantage over those firms who are unable to hedge their asset(s). That is, the gains from hedging are asymmetric. Neutralization of business risk by hedging does not imply a zero standard deviation of returns since the process of hedging requires the acceptance of moral risk. Just as variability of returns due to business risk is decreased by hedging, the exposure to
41 moral risk is increased. Complete neutralization of business risk would leave the asset with two possible states of the world - a successful and an unsuccessful hedged position. The first would represent the return associated with the most successful state in a prehedged world, i.e., the most profitable opportunity in a normal fair market.5 The unsuccessful hedged state would represent a loss, at the limit, equal to the potential gain had the hedge been successful, assuming no punitive damages (costs). This loss is brought about by the fact that in equilibrium the opportunity cost of the asset is just offset by the present value of its future returns, i.e., the net present value is zero. If p is the probability of an unsuccessful hedge and l-p is the probability of a successful hedge, then the expected return would be, E (rh) = (1-p) rz + p(+
(7)
= rz( 1-2p)
(8)
and the variance and standard deviation would be, VAR(rh) = 4rz =‘h
=2rZ
p(l-p)
/pm
(9)
(10)
where, rh is the return in a hedged, unfair market world and rz
‘Unfair business practices may also raise the expected return as well as reduce the business risk. Thus, the 10s may be more than the maximum fair market return. The increase in the expected return would, of course, be net of any cost associated with the hedging process.
42
the maximum gain in an unhedged, fair market world.6 Since the product p(l-p) is maximized at p = S, the maximum variance and standard deviation is respectively, rz and rz. Substituting this result into equation 6 yields a maximum p, equal to
is
0, (rzho). As p goes from 0 in an unhedged position to .5 in a hedged position, /3, rises to its maximum. As p approaches 1.0, as a limit, the variance approaches 0 as does the risk. That is, the likelihood of an unsuccessful hedge becomes more certain. Profit maximizing, risk averse organizations would eschew states in which the probability of an unsuccessful hedge were greater than .5 since the combinations of expected returns and risks are superior in all caseswhere p < .5 to casesin which p < .5.’ The range of possibilities for ou and flu are depicted in Figure 1.
6This argument assumes the total loss of the asset if the hedge is unsuccessful. Allowing for partial losses and relaxing the assumption of no punitive damages, the expected return would be equal to, E(rh) = r&l-p)
+ pi-k,
+ Wad)1
= rs [(l-p) - Ap(l+d)l
053)
where A denotes the extent of asset loss if the hedge is unsuccessful or, equivalently, only a partial hedge is employed, subject to 0 ( h < 1. Equation 8a assumes the punitive damages (d) are a multiple of the actual damages suffered (ha). 7
The present diission has deferred consideration of unfair business practices effects on expected returns other than to state that the two are likely to be positively related. Note must be made, however, of the effect of p on the expected returnin a two state world as depicted here. If p = 0, then E(rh ) = ra while if p = 2, then E(rh) = 0. These results indicate the intuitive notion that as the probability of failure increases the expected return deemases. This decrease could be offset by the possibility of unfair business practices increasing the value of ra. Where orb is maximized (p = .s) these
attempts would be futile since E(rh) = 0 regardless of the value of rs.
43 Ngure
1
a0 = 0u a
44
/3$o represents the fair market, unlevered systematic risk, that is, where ou = uo. 00, represents the moral risk associated with cru which in turn is a function of p depicted by OP. Point 0 represents the total risk if business risk were completely neutralized and p were zero. If p 2 pe, then ou cue and /3, : PO.Therefore, in the range 0 i p c pe the overall risk of the asset is less than or equal to the fair market risk (PO). The use of unfair businesspractices thus enablesthe firm to acquire what would otherwise be an unprofitable asset.That is, the combination of the asset’sexpected return and risk can be sufficiently altered to changethe net present value (NPV) from negative to positive. The firm’s security value and risk combination would reflect this acquisition. It is not necessary for business risk to be completely neutralized, i.e., /3, = 0. Total risk may be reduced as long as the reduction in business risk is greater than the concomitant increase in moral risk. The caseoutlined above, then, representsthe special case where risk is reduced by the maximum possible amount given the structure of moral risk. Figure 2 depicts the reduction in PO to /3o. The overall risk would then be the sum of /3,, and flu. Thus, the more general case is where 0 < flo 2 po as long as /3, + /3u = &, < PO. A less than complete neutrahzation of business risk means that the range of p in which /3; -ZPOis narrowed which in turn means fewer opportunities to alter the NPV’s of assets through the use of unfair businesspractices.
45
6
The tradeoff of moral risk and business risk is a relevant consideration only for insiders. The use of unfair business practices cannot be generally known to the market since this knowledge would expose the firm to punitive action by the authorities. At best, all the market perceives is growth in assets and share value. The market is unaware that the increased growth was actually the results of insiders’ decisions to incur moral risk rather than the result of increased operating efficiency, market shrewdness or any other legitimate reason. Had complete knowledge been available to the market, growth would have been moderated by actions of the authorities and/or investor crime aversion differing from that of insiders. Thus, complete knowledge of the effects of moral risk on systematic risk is relevant only to the decision maker who must weigh all risks not just those perceived by the market. Assuming that insiders seek to minimize actual and not just perceived risks of the market, decisions to utilize unfair business practices are constrained in the indicated fashion by the trade-off of moral and businessrisk. If the gains from hedging are not perceived by the market and cannot be discretely “leaked” they may simply end up accruing to insiders. Conceivably, the entire hedging process could be used as a means of maximizing insider wealth. Since corporate limited liability does not extend to insiders for criminal acts, they assume substantial personal risk by hedging. The firm may survive the loss of the asset(s) in question, but the insider(s) responsible could suffer total loss of wealth. The gains, therefore, could simply be insider compensation for the risks assumed. If this result were the case, hedging would produce no perceptible change in the risk-return relation in the capital market. Indeed, the impact of the discovery of hedging on the firm’s securities would be nominal or limited to the value of the asset(s)involved.
47 Summary and Conclusion Normal businessrisk associatedwith any assetcan be reduced through various amounts and/or combinations of unfair business practices. At the limit systematic risk can be completely neutralized through this hedging process. An additional goal of the hedging process, only tangentially considered in this discussion, would be the enhancement of the asset’sexpected returns. Neutralization of business risk through hedging is only accomplished at the expense of incurring the moral risk of disclosure and loss of the asset’sreturn. Thus, the assethas only two states of the world, a successful hedge and an unsuccessful hedge each with its respective probability. Figure 1 depicted a positive range of p in which the moral risk incurred is less than the reduction in businessrisk thereby making their sum less than the unhedged equivalent. Assuming the asset’sexpected return does not fall, the reduction in risk produces an opportunity in which the risk-return combination is superior to that produced in an unhedgedworld. As stated at the outset, this finding is contrary to the naive notion that utilization of unfair business practices would simply add to the risk associatedwith the operation of an asset.Partial hedging with partial gains or losses can also produce exploitable opportunities. The potential for gain represents an incentive, for the crime neutral, profit maximizing decision maker to engage in unfair business methods. The gains from such growth may be sufficient enough to induce some crime adversedecision makers to engage in similar activities. The gains need not result in increased share value since information of their existence could result in exposure of the methods whereby they were obtained. The gains may simply accrue to those insiders responsible for their existence and subject to their risks.
REFERENCES
1.
Block, M. K. and J. M. Heineke, “A Labor Theoretic Analysis of the Criminal Choice,” American Economic Review, Vol. LXU, No. 3, June 1975, pp. 314-325.
2.
Cloninger, Dale O., “Risk, Security, Insurance, and the Cost of Protection,” Southern Business Review, Fall 1977, pp. 1-7.
3.
Cloninger, Dale O., “Risk, Arson, and Abandonment,” The Journal of Risk and Insurance, Vol. XLVIII, No. 3, pp. 494-505.
4.
Copeland, Thomas E. and J. Fred Weston, Financial Theory and Corporate Policy, Addison-Wesley, Reading, Massachusetts, 1979.
5.
Jenson, Michael C., “Capital Markets: Theory and Practice,” Bell Journal of Economics and Management Science, Vol. 3, 1972, pp. 357-398.
6.
Litner, John, “Security Prices, Risk and Maximal Gains from Diversification,” Journal of Finance, Vol. 30, December 1965, pp. 587616.
7.
Mehr, Robert I. and Emerson Cammack, FrincipZes of Znsur ante, Sixth Edition, Richard D. Irwin, Inc., Homewood, Illinois, 1976.
49
8.
Polinsky, Mitchell A. and Steven Shavell, “The Optimal Tradeoff Between the Probability and Magnitude of Fines,” American Economic Review, Vol. 69, No. 5, pp. 880-89 1.
9.
Sharpe, William F., Investments, Englewood Cliffs, N. J., Prentice-Hall, Inc., 1978.
10. Van Home, James C., Financial Management and Policy, Fifth Edition, Prentice-Hall, Inc., Englewood Cliffs, N.J. 1980.
MORAL AND SYSTEMATIC RISK: A RATIONALE FOR UNFAIR BUSINESS PRACTICE
Dale 0. Cloningeri
Introduction
The objectives of this paper are (1) to distinguish moral risk (the risk associated with unfair business practice) from normal business (operating) risk and financial (default) risk; (2) to analyze the effect of moral risk on the systematic risk of a nonlevered asset; and (3) to discuss the rationale for businessbehavior which employs unfair (illegal) businesspractice. The discussion will show how the use of business practices that involve moral risk can decrease the unlevered, systematic risk of an asset. This finding contrasts with the naive notion that acceptance of moral risk would simply add to the risk associated with the operation of a nonlevered asset. The possibility of reducing business risk by the acceptance of smaller amounts of moral risk could provide a rationale for the use of certain unorthodox business practices. Moral Risk
Moral risk, as defined herein, is not unlike and indeed is a derivative of the concept of moral hazard as used in the field of insurance. In their principles text, Mehr and Cammack (7) defined moral hazard as the possibility that an individual will deliberately
‘Dale 0. Cloningct is a professor of finance and economics at the University of Hou,ston at Clear Lake City in Houston Texas.
34
bring about a loss for which the individual is insured. Moral risk is not confined to actions involving insured hazards, however. Moral risk is the risk of exposure, including arrest and conviction for illegitimate acts, of a wide range of activities involving illegal, immoral, unethical or even unfair practices. Examples would include arson, bribery, blackmail, cheating, corporate espionage, extortion, fraud, patent or copyright infringement, lying or gross misrepresentation, price fixing and counterfeiting among others. The possibility of exposure affects business risk associated with the asset through the effect exposure may have on the variability of anticipated cash flows. The moral2 risk of any action is manifested in the increased uncertainty of the possible returns, i.e., the increased variability of the expected returns of the assetsince cash flows may be affected by moral, legal or social sanctions. In a discussion of expected return, Polinsky and Shave11 (8) addressedthe issue of the determination of the optimal probability of arrest and fme (moral risk). The authors pointed out that under either an assumption of risk neutrality or risk aversion those individuals whose private gains exceeded the external costs of their activity would participate in the activity. The optimal probability of capture would be as low as possible for risk neutral individuals and one for individuals who are risk averse.The risk averse condition holds only if the costs of capture are sufficiently low. Experience indicates the actual probability of capture is quite low. This experience may indicate either a suboptimal probability of capture for risk averse individuals or, as suggestedby Polinsky and Shave& the cost of capture is sufficiently high to drop the
‘Use of the word moral in this context migbt appear inappropriate inasmuch as the actions could be considered immoral. The use of the word moral merely reflects the potential loss of moral standing as opposed to the commitment of immoral acts.
35 optimal probability to virtually zero. If the latter were the case, the optimal probability of capture would be low for both risk neutral and risk averse individuals. Near zero probability of capture can produce conditions in which the assumption of moral risk will result in disproportionately less business risk and hence less overall risk. This possibility is the subject of the remainder of this paper. Risk and Crime Aversion Business or operating risk refers, in the financial literature, to the variability of returns of cash flows. In a world of risk averse investors the market will only compensateinvestors for systematic (market) risk and not for unsystematic (random) risk that may be diversified away. The risk of an unlevered firm is a unique function of that firm’s correlation of returns with the market as a whole. An efficient market will force returns on securities to a level that is commensurate with the systematic risk identified by the covariance of returns. That is, an efficient market prevents expected returns in excess of that generally compensated by the market for the level of risk incurred. The possibility of using unfair/or illegitimate business practices together with the presence of moral and/or legal sanctions designed to prevent such practices could create opportunities which decision makers, if they were so inclined, could exploit. To do so, of course, would expose the decision makers and the asset’s expected returns to moral risk. The decision to utilize unfair practices would then depend on how the asset’s business risk is affected by these practices and the degree to which the decision makers are crime3 averse.
3Crime is used here as a catch-all term for all of those practices that produce moral risk whether they are specifically forbidden by law or not.
36 Crime aversion can be treated analogously to risk aversion. Decision makers can be characterized as either crime averse, crime neutral or crime prone. For the latter group, value maximizing conditions are not necessary and may be more than sufficient. They would, everything the same, choose that alternative for which the potential returns were the greatest regardlessof its fairness or legality. For crime neutral decision makers, value maximizing conditions are both necessary and sufficient before decisions to commit unfair or illegitimate acts will be made. Value maximizing conditions are necessary but may be insufficient for the crime averse to employ unfair practices. But like risk aversion, crime aversion may be overcome by the promise of sufficiently high returns or low risks. Like risk, a premium for the commission of unfair practices would be demanded and the size of that premium would be a direct function of the extent of the decision maker’s crime aversion. The scope of this paper does not permit a complete discussion of crime aversion. However, Block and Heineke (1) provide an insightful discussion into this issue. For the remainder of this paper decision makers will be assumed to be crime neutral. The Effect of Moral Risk on Systematic Risk Virtually all financial texts measure systematic risk, in a manner of Sharpe (8) and Litner (6), as the covariance between returns for any asset j and the market portfolio divided by the variance of returns for the market portfolio. The result is referred to as Beta and is defined as a measureof the responsivenessof the asset’s returns to those of the market portfolio. Symbolically, COV(j ,m) (1)
P = VAR(m)
37
The covariance may also be expressed as the product of the correlation coefficient ( Pjm) and the standard deviation of j and the standard deviation of m. Or,
P =
Pjrn’j’rn (2)
2 ‘rn
P =
pjm”j 3n
Where Pjm and Uj are the ‘fair’correlation coefficient and standard deviation of asset j respectively and urn the standard deviation of the market. If /3, is defined as the fair market measure of systematic risk and p, as the “unfair” market measure of systematic risk, then the theoretical relationship between them may be expressedby, 4
cov
u
o(I urn 8” = EOY
0
u u
”
.
80
0
au om COV
U
= cov
0
aa
om. -uu om
D
0
u. 0
80
mv”
with the relationship of ou and covu being indeterminate.
38
flu pu. % -=00 PO 00
or
(4)
’
5.l Pu
=“u PO
.
--PO
(5)
Oo
The objectives of unfair businesspractices can be assumed to be the same as fair businesspractices - maximization of return for any given level of risk and minimization of risk for any given level of return. From equation 5 it is clear that the effect of unfair business practice on systematic risk is manifested in the ratios of correlation coefficients and standard deviations of assetsdiffering only in the extent to which unfair businesspractices are employed in their operation. The coefficient of correlation between the asset and the market may or may not be affected by the firm’s efforts to reduce the asset’s systematic risk. That is, efforts to decrease the asset’s risk by reducing the variability of its returns do not necessarily result in a reduction of the asset’scorrelation with the market. In fact, a smaller standard deviation of returns is not inconsistent with either a smaller or larger correlation of returns. At the limit, of course, a zero standard deviation would also mean a zero correlation. If efforts to reduce the variability of returns affect the correlation of returns randomly with a mean of zero, then the correlation can be assumed to be independent of these efforts. That is, UP,)
= E(P,),
or
39 A PO = lo, + e, - e, where e, and eu are the error terms associatedwith the random variables p, and p, respectively. Then equation 5 becomes
P,=
4l + eu /r
4.l
. %l -PO
+
e,
-
e,
uO
If e, and eu are independent and e, is randomly distributed with a mean of zero, then
= 1, and
P,
%I =-00 OO
The supply of unfair business practices, which includes but is not limited to bribery, theft, arson, espionage and fraud, is assumed to be sufficient to allow management to protect any potential investment opportunity. Much like the possibility of abandonment places a floor below the returns associated with the operation of an asset, unfair business practices such as arson, as one form of abandonment, may do the same. That is, if the capitalized returns of the asset fall below the value of abandonment by arson or any other means, the asset is abandoned and future losses prevented. If the abandonment value were high enough any return less than the maximum potential would result in abandonment. The possibility of arson does not limit abandonment value to something equal to or less than the original purchase
40 price or even its current legitimate replacement value. Various schemes exist to raise arson abandonment value high enough to not only prevent any future loss but to cover any past losses as well. In a recent article, Cloninger (3) demonstrates how and under what conditions arson would be the maximizing form of abandonment. In a similar manner bribery and other unfair practices may allow management to guarantee contract approval, provide substandard performance, restrain competition and employ other actions which result in a modification of the distribution of potential returns. The modification could take the form of both higher expected value and a smaller standard deviation. In this fashion, this process of “hedging” of what otherwise may be a fair or legitimate project through the use of unfair and/or illegitimate business practices reduces the operating risk of the project. At the limit, the asset’soperating risk could be completely neutralized and its expected return maximized. The asset’sdistribution of returns would then take the form of a vertical line at its maximum potential return. Potentially the whole market could exploit the gains from hedging. If the impact were symmetric across all assets there would be no exploitable opportunities as a result of the hedging process. However, the market is unable to duplicate the extent of the gains from hedging becauseof the presenceof legal,.moral and ethical sanctions that exist to prohibit such behavior. Thus, decision makers who are successful in hedging an asset’sbusiness risk have an advantage over those firms who are unable to hedge their asset(s). That is, the gains from hedging are asymmetric. Neutralization of business risk by hedging does not imply a zero standard deviation of returns since the process of hedging requires the acceptance of moral risk. Just as variability of returns due to business risk is decreased by hedging, the exposure to
41 moral risk is increased. Complete neutralization of business risk would leave the asset with two possible states of the world - a successful and an unsuccessful hedged position. The first would represent the return associated with the most successful state in a prehedged world, i.e., the most profitable opportunity in a normal fair market.5 The unsuccessful hedged state would represent a loss, at the limit, equal to the potential gain had the hedge been successful, assuming no punitive damages (costs). This loss is brought about by the fact that in equilibrium the opportunity cost of the asset is just offset by the present value of its future returns, i.e., the net present value is zero. If p is the probability of an unsuccessful hedge and l-p is the probability of a successful hedge, then the expected return would be, E (rh) = (1-p) rz + p(+
(7)
= rz( 1-2p)
(8)
and the variance and standard deviation would be, VAR(rh) = 4rz =‘h
=2rZ
p(l-p)
/pm
(9)
(10)
where, rh is the return in a hedged, unfair market world and rz
‘Unfair business practices may also raise the expected return as well as reduce the business risk. Thus, the 10s may be more than the maximum fair market return. The increase in the expected return would, of course, be net of any cost associated with the hedging process.
42
the maximum gain in an unhedged, fair market world.6 Since the product p(l-p) is maximized at p = S, the maximum variance and standard deviation is respectively, rz and rz. Substituting this result into equation 6 yields a maximum p, equal to
is
0, (rzho). As p goes from 0 in an unhedged position to .5 in a hedged position, /3, rises to its maximum. As p approaches 1.0, as a limit, the variance approaches 0 as does the risk. That is, the likelihood of an unsuccessful hedge becomes more certain. Profit maximizing, risk averse organizations would eschew states in which the probability of an unsuccessful hedge were greater than .5 since the combinations of expected returns and risks are superior in all caseswhere p < .5 to casesin which p < .5.’ The range of possibilities for ou and flu are depicted in Figure 1.
6This argument assumes the total loss of the asset if the hedge is unsuccessful. Allowing for partial losses and relaxing the assumption of no punitive damages, the expected return would be equal to, E(rh) = r&l-p)
+ pi-k,
+ Wad)1
= rs [(l-p) - Ap(l+d)l
053)
where A denotes the extent of asset loss if the hedge is unsuccessful or, equivalently, only a partial hedge is employed, subject to 0 ( h < 1. Equation 8a assumes the punitive damages (d) are a multiple of the actual damages suffered (ha). 7
The present diission has deferred consideration of unfair business practices effects on expected returns other than to state that the two are likely to be positively related. Note must be made, however, of the effect of p on the expected returnin a two state world as depicted here. If p = 0, then E(rh ) = ra while if p = 2, then E(rh) = 0. These results indicate the intuitive notion that as the probability of failure increases the expected return deemases. This decrease could be offset by the possibility of unfair business practices increasing the value of ra. Where orb is maximized (p = .s) these
attempts would be futile since E(rh) = 0 regardless of the value of rs.
43 Ngure
1
a0 = 0u a
44
/3$o represents the fair market, unlevered systematic risk, that is, where ou = uo. 00, represents the moral risk associated with cru which in turn is a function of p depicted by OP. Point 0 represents the total risk if business risk were completely neutralized and p were zero. If p 2 pe, then ou cue and /3, : PO.Therefore, in the range 0 i p c pe the overall risk of the asset is less than or equal to the fair market risk (PO). The use of unfair businesspractices thus enablesthe firm to acquire what would otherwise be an unprofitable asset.That is, the combination of the asset’sexpected return and risk can be sufficiently altered to changethe net present value (NPV) from negative to positive. The firm’s security value and risk combination would reflect this acquisition. It is not necessary for business risk to be completely neutralized, i.e., /3, = 0. Total risk may be reduced as long as the reduction in business risk is greater than the concomitant increase in moral risk. The caseoutlined above, then, representsthe special case where risk is reduced by the maximum possible amount given the structure of moral risk. Figure 2 depicts the reduction in PO to /3o. The overall risk would then be the sum of /3,, and flu. Thus, the more general case is where 0 < flo 2 po as long as /3, + /3u = &, < PO. A less than complete neutrahzation of business risk means that the range of p in which /3; -ZPOis narrowed which in turn means fewer opportunities to alter the NPV’s of assets through the use of unfair businesspractices.
45
6
The tradeoff of moral risk and business risk is a relevant consideration only for insiders. The use of unfair business practices cannot be generally known to the market since this knowledge would expose the firm to punitive action by the authorities. At best, all the market perceives is growth in assets and share value. The market is unaware that the increased growth was actually the results of insiders’ decisions to incur moral risk rather than the result of increased operating efficiency, market shrewdness or any other legitimate reason. Had complete knowledge been available to the market, growth would have been moderated by actions of the authorities and/or investor crime aversion differing from that of insiders. Thus, complete knowledge of the effects of moral risk on systematic risk is relevant only to the decision maker who must weigh all risks not just those perceived by the market. Assuming that insiders seek to minimize actual and not just perceived risks of the market, decisions to utilize unfair business practices are constrained in the indicated fashion by the trade-off of moral and businessrisk. If the gains from hedging are not perceived by the market and cannot be discretely “leaked” they may simply end up accruing to insiders. Conceivably, the entire hedging process could be used as a means of maximizing insider wealth. Since corporate limited liability does not extend to insiders for criminal acts, they assume substantial personal risk by hedging. The firm may survive the loss of the asset(s) in question, but the insider(s) responsible could suffer total loss of wealth. The gains, therefore, could simply be insider compensation for the risks assumed. If this result were the case, hedging would produce no perceptible change in the risk-return relation in the capital market. Indeed, the impact of the discovery of hedging on the firm’s securities would be nominal or limited to the value of the asset(s)involved.
47 Summary and Conclusion Normal businessrisk associatedwith any assetcan be reduced through various amounts and/or combinations of unfair business practices. At the limit systematic risk can be completely neutralized through this hedging process. An additional goal of the hedging process, only tangentially considered in this discussion, would be the enhancement of the asset’sexpected returns. Neutralization of business risk through hedging is only accomplished at the expense of incurring the moral risk of disclosure and loss of the asset’sreturn. Thus, the assethas only two states of the world, a successful hedge and an unsuccessful hedge each with its respective probability. Figure 1 depicted a positive range of p in which the moral risk incurred is less than the reduction in businessrisk thereby making their sum less than the unhedged equivalent. Assuming the asset’sexpected return does not fall, the reduction in risk produces an opportunity in which the risk-return combination is superior to that produced in an unhedgedworld. As stated at the outset, this finding is contrary to the naive notion that utilization of unfair business practices would simply add to the risk associatedwith the operation of an asset.Partial hedging with partial gains or losses can also produce exploitable opportunities. The potential for gain represents an incentive, for the crime neutral, profit maximizing decision maker to engage in unfair business methods. The gains from such growth may be sufficient enough to induce some crime adversedecision makers to engage in similar activities. The gains need not result in increased share value since information of their existence could result in exposure of the methods whereby they were obtained. The gains may simply accrue to those insiders responsible for their existence and subject to their risks.
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