This study examines the economic rationale for limiting firms' risk. We argue that risk increases the cost of doing business for two reasons. First, risk causes operating inefficiencies and imposes adjustment costs. Second, diverse stakeholders must be compensated for their risk-bearing. We find empirical support for positive risk-cost relations using various model specifications and risk measures, and across different manufacturing industries and time periods. We also examine the direct and moderating effects of bankruptcy risk. The relation of distance from bankruptcy to firms' costs depends on whether relations are contemporaneous or lagged and whether bankruptcy is an immediate threat or not.
Get full access to this article
View all access options for this article.
References
1.
Aaker, D. A. and Jacobson, R. (1990) `The Risk of Marketing: The Roles of Systematic, Uncontrollable, and Controllable Unsystematic, and Downside Risk', in R. A. Bettis and H. Thomas (eds) Risk, Strategy, and Management, pp. 137-160. Greenwich, CT: JAI Press .
2.
Alchien, A. A. and Demsetz, H. (1972) `Production, Information Costs, and Economic Organization' , American Economic Review62: 777-795 .
3.
Altman, E. I. (1983) Corporate Distress: A Complete Guide to Predicting, Avoiding, and Dealing with Bankruptcy. New York: Wiley .
4.
Amit, R. and Wernerfelt, B. (1990) `Why Do Firms Reduce Business Risk?' , Academy of Management Journal33: 520-533 .
5.
Baird, I. S. and Thomas, H. (1990) `What Is Risk Anyway?: Using and Measuring Risk in Strategic Management', in R. A. Bettis and H. Thomas (eds) Risk, Strategy, and Management, pp. 21-54. Greenwich, CT: JAI Press .
6.
Baltagi, B. H. and Wu, P. X. (1999) `Unequally Spaced Panel Data Regression with AR(1) Disturbance' , Econometric Theory15: 814-823 .
7.
Bettis, R. A. (1983) `Modern Financial Theory, Corporate Strategy and Public Policy: Three Conundrums' , Academy of Management Review8: 406-415 .
8.
Bowman, E. H. (1980) `A Risk/Return Paradox for Strategic Management' , Sloan Management Review21: 17-31 .
9.
Bromiley, P. (1991) `Testing a Causal Model of Corporate Risk Taking and Performance' , Academy of Management Journal34: 37-59 .
10.
Bromiley, P., Miller, K. D. and Rau, D. (2001) `Risk In Strategic Management Research', in M. A. Hitt, R. E. Freeman and J. S. Harrison (eds) The Blackwell Handbook of Strategic Management, pp. 259-288. Malden, MA: Blackwell .
11.
Chatterjee, S., Lubatkin, M. H. and Schulze, W. S. (1999) `Toward a Strategic Theory of Risk Premium: Moving Beyond CAPM' , Academy of Management Review24: 556-567 .
12.
Clarkson, M. B. E. (1995) `A Stakeholder Framework for Analyzing and Evaluating Corporate Social Performance' , Academy of Management Review20: 92-117 .
13.
Cohen, J. (1978) `Partialed Products Are Interactions; Partialed Powers Are Curve Components' , Psychological Bulletin85: 858-866 .
14.
Cornell, B. and Shapiro, A. C. (1987) `Corporate Stakeholders and Corporate Finance' , Financial Management16(1): 5-14 .
15.
Cyert, R. M. and March, J. G. (1963) A Behavioral Theory of the Firm. Englewood Cliffs, NJ: Prentice-Hall .
16.
Deephouse, D. L. and Wiseman, R. M. (2000) `Comparing Alternative Explanations for Accounting Risk-Return Relations' , Journal of Economic Behavior and Organization42: 463-482 .
17.
Diamond, D. and Verrecchia, R. (1982) `Optimal Managerial Contracts and Equilibrium Security Prices' , Journal of Finance37: 275-288 .
18.
Donaldson, T. and Preston, L. E. (1995) `The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications' , Academy of Management Review20: 65-91 .
19.
Fiegenbaum, A. and Karnani, A. (1991) `Output Flexibility - A Competitive Advantage for Small Firms' , Strategic Management Journal12: 101-114 .
20.
Fiegenbaum, A. and Thomas, H. (1990) `Stakeholder Risks and Bowman's Risk/Return Paradox: What Risk Measure Is Relevant for Strategists?', in R. A. Bettis and H. Thomas (eds) Risk, Strategy, and Management, pp. 111-136. Greenwich, CT: JAI Press .
21.
Freeman, R. E. (1984) Strategic Management: A Stakeholder Approach. Boston, MA: Pitman .
22.
Giddy, I. H. (1994) `Exchange Rate Volatility, Hedging, and the Cost of Capital', in Y. Amihud and R. M. Levich (eds) Exchange Rates and Corporate Performance, pp. 155-162. New York: Irwin .
23.
Hart, O. and Holmström, B. (1987) `The Theory of Contracts' , in T. F. Bewley (ed.) Advances in Economic Theory: Fifth World Congress, pp. 71-155 . Cambridge: Cambridge University Press.
24.
Jemison, D. B. (1987) `Risk and the Relationship Among Strategy, Organizational Processes, and Performance' , Management Science33: 1087-1101 .
25.
Jensen, M. (1986) `Agency Costs of Free Cash Flow, Corporate Finance and Takeovers' , American Economic Review76(2): 323-329 .
26.
Jones, T. M. and Wicks, A.C. (1999) `Convergent Stakeholder Theory' , Academy of Management Review24: 206-221 .
27.
Kenny, D. A. (1979) Correlation and Causality. New York: John Wiley .
28.
Lev, B. (1969) `Industry Averages as Targets for Financial Ratios' , Journal of Accounting Research7(2): 290-299 .
29.
Lintner, J. (1965) `The Valuation of Risk Assets and the Selection of Risky Investment in Stock Portfolios and Capital Budgets' , Review of Economics and Statistics47: 13-37 .
30.
Lubatkin, M. and Chatterjee, S. (1994) `Extending Modern Portfolio Theory into the Domain of Corporate Diversification: Does It Apply?' , Academy of Management Journal37: 109-136 .
31.
March, J. G. and Shapira, Z. (1987) `Managerial Perspectives on Risk and Risk Taking' , Management Science33: 1404-1418 .
32.
Markowitz, H. M. (1959) Portfolio Selection. New York: John Wiley .
33.
Miller, K. D. (1992) `A Framework for Integrated Risk Management in International Business' , Journal of International Business Studies23: 311-331 .
34.
Miller, K. D. (1998) `Economic Exposure and Integrated Risk Management' , Strategic Management Journal19: 497-514 .
35.
Miller, K. D. and Bromiley, P. (1990) `Strategic Risk and Corporate Performance: An Analysis of Alternative Risk Measures' , Academy of Management Journal33: 756-779 .
36.
Miller, K. D. and Leiblein, M. J. (1996) `Corporate Risk-Return Relations: Returns Variability Versus Downside Risk' , Academy of Management Journal39: 91-122 .
37.
Miller, K. D. and Reuer, J. J. (1996) `Measuring Organizational Downside Risk' , Strategic Management Journal17: 671-691 .
38.
Mitchell, R. K., Agle, B. R. and Wood, D. J. (1997) `Toward a Theory of Stakeholder Identification and Salience: Defining the Principle of Who and What Really Counts' , Academy of Management Review22: 853-886 .
39.
Mitchell, T. R. and James, L. R. (2001) `Building Better Theory: Time and the Specification of When Things Happen' , Academy of Management Review26: 530-547 .
40.
Nance, D., Smith, C. and Smithson, C. (1993) `On the Determinants of Corporate Hedging' , Journal of Finance48: 267-284 .
41.
Opler, T. C. and Titman, S. (1994) `Financial Distress and Corporate Performance' , Journal of Finance49: 1015-1040 .
42.
Rawls, S. W., III and Smithson, C. W. (1990) `Strategic Risk Management' , Journal of Applied Corporate Finance2(4): 6-18 .
43.
Sanchez, R. (1993) `Strategic Flexibility, Firm Organization, and Managerial Work in Dynamic Markets: A Strategic-Options Perspective', in P. Shrivastava, A. Huff and J. Dutton (eds) Advances in Strategic Management, Vol. 9, pp. 251-291. Greenwich, CT: JAI Press .
44.
Sanchez, R. (1995) `Strategic Flexibility in Product Competition' , Strategic Management Journal16: 135-159 .
45.
Shapiro, A. C. and Titman, S. (1986) `An Integrated Approach to Corporate Risk Management', in J. M. Stern and D. H. Chew, Jr. (eds) The Revolution in Corporate Finance, pp. 215-229. Oxford: Blackwell .
46.
Sharpe, W. F. (1964) `Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk' , Journal of Finance19: 425-442 .
47.
Shavell, S. (1979) `Risk Sharing and Incentives in the Principal and Agent Relationship' , Bell Journal of Economics10: 55-73 .
48.
Smith, C. W. and Stulz, R. M. (1985) `The Determinants of Firms' Hedging Policies' , Journal of Financial and Quantitative Analysis20: 391-405 .
49.
Stulz, R. M. (1984) `Optimal Hedging Policies' , Journal of Financial and Quantitative Analysis19: 127-140 .
50.
Stulz, R. M. (1996) `Rethinking Risk Management' , The Bank of America Journal of Applied Corporate Finance9(3): 8-24 .
51.
Trueman, B. and Titman, S. (1988) `An Explanation for Accounting Income Smoothing' , Journal of Accounting Research26(Supplement): 127-143 .
52.
Wang, H., Barney, J. B. and Reuer, J. J. (2003) `Stimulating Firm-Specific Investment Through Risk Management' , Long Range Planning36: 49-59 .
53.
Weitzman, M. and Kruse, D. (1990) `Profit Sharing and Productivity', in A. Blinder (ed) Paying for Productivity, pp. 95-141. Washington, DC: Brookings Institution .
54.
Wiseman, R. M. and Bromiley, P. (1996) `Toward a Model of Risk in Declining Organizations: An Empirical Examination of Risk, Performance and Decline' , Organization Science7: 524-543 .
55.
Wruck, K. (1990) `Financial Distress, Reorganization and Organizational Efficiency' , Journal of Financial Economics27: 419-444 .
