How Do Investors Judge the Risk of Derivative and Non-Derivative Financial Items?
Posted: 9 Jun 2001
Date Written: May 22, 2001
The purpose of this paper is twofold. First, we provide descriptive evidence on how investors perceive financial risk. Specifically, we identify the dimensions that investors consider when judging the risk of financial items, such as bonds and interest rate swaps. Second, we investigate whether investors judge the risks related to derivatives differently than the risks related to non-derivatives. Our research is motivated by increased attention to risk disclosures by standard-setting bodies and a lack of understanding about how investors assess financial risk. Studying this issue in the financial accounting domain is important, because prior research demonstrates that what we know about risk in one domain may not generalize to other domains.
To provide evidence on risk in a financial accounting context, we conducted two experiments. Our results show that investors' risk assessments are best described by a hybrid model that includes variables from both the decision-theory and psychology literatures. Specifically, investors judging the risk of financial items do consider the traditional decision-theoretic risk dimensions - probabilities and outcomes. However, in contrast to the perspective that risk is equivalent to variance, investors put greater weight on loss probabilities and outcomes than they do on gain probabilities and outcomes. Further, investors consider gains and risk to be positively associated. This result is in direct contrast to substantial research in psychology, as well as anecdotal claims in accounting that gain information reduces risk. Our results also show that investors bring additional dimensions to their risk judgments-dimensions that have not been explicitly recognized in finance and accounting models of risk. Specifically, investors judging risk also consider the degree to which they worry, the potential for catastrophic outcomes, management's knowledge and their own knowledge, the degree to which the investment is voluntary, and management's control. Finally, our results show that investors consider derivatives to be riskier than non-derivatives even when the underlying economic exposure is held constant. Our study results should be of use to regulators issuing risk-related standards and researchers exploring the implications of those risk standards.
Keywords: Derivatives, risk, financial instruments, judgment and decision making
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