Risk propensity and firm performance: A study of the petroleum exploration industry

This paper explores the differences in observed risk propensity among petroleum firms and their impact on firm performance. In this work, the authors: (1) develop a decision theoretic model which measures a firm’s risk propensity in the form of an ‘implied’ utility function; (2) investigate changes in corporate risk propensity with respect to changes in firm size; and (3) examine the relationships between firms, risk propensities and alternative dimensions of economic performance, including ex post risk and return measures. They also develop a new risk propensity measure, the Risk Tolerance Ratio (RTR), which controls for firm size and allows firms to be differentiated in terms of relative risk propensity. The motivation for this work is managerial concerns regarding appropriate risk-taking behavior and the effect of risky choice on firm performance. This methodology has importance business strategy implications in that we are able to make strong inferences about causal relationships between ex ante risk-taking and performance. The present findings are compelling in that corporate risk propensity seems to matter, and that decisions about corporate risk policy have a significant impact on the petroleum firm’s economic performance.