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Dale 0. Cloningeri
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 business behavior which
employs unfair (illegal) business practice. 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.
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 mani-
fested in the increased uncertainty of the possible returns, i.e.,
the increased variability of the expected returns of the asset since
cash flows may be affected by moral, legal or social sanctions.
In a discussion of expected return, Polinsky and Shave11
(8) addressed the issue of the determination of the optimal pro-
bability 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 suggested by 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.
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 cap-
ture 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
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 compensate investors for systematic
(market) risk and not for unsystematic (random) risk that may be
diversified away. The risk of an unlevered firm is a unique func-
tion of that firms 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 prac-
tices 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
assets expected returns to moral risk. The decision to utilize
unfair practices would then depend on how the assets business
risk is affected by these practices and the degree to which the
decision makers are crime3 averse.
Crime 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.
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 maxi-
mizing conditions are not necessary and may be more than suffi-
cient. They would, everything the same, choose that alternative
for which the potential returns were the greatest regardless of 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 insuffi-
cient 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 makers 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 measure of the responsiveness of the
assets returns to those of the market portfolio. Symbolically,
COV(j ,m)
P = (1)
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.
P =
P =
Where Pjm
and Uj are the faircorrelation coefficient and standard
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 syste-
matic risk, then the theoretical relationship between them may be
expressed by, 4
8 = EOY
. 80
aa D
om. u.
uu 0
om 0 80
with the relationship of ou and covu being indeterminate.
flu pu. %
-=- - or
00 PO 00
Pu =u . --PO
The objectives of unfair business practices can be assumed to
be the same as fair business practices - 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 busi-
ness practice on systematic risk is manifested in the ratios of
correlation coefficients and standard deviations of assets differing
only in the extent to which unfair business practices are employed
in their operation.
The coefficient of correlation between the asset and the
market may or may not be affected by the firms efforts to
reduce the assets systematic risk. That is, efforts to decrease the
assets risk by reducing the variability of its returns do not
necessarily result in a reduction of the assets correlation 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,
= E(P,), or
= lo, + e, - e,
where e, and eu are the error terms associated with the random
variables p, and p, respectively. Then equation 5 becomes
4l + eu . %l
P, =
+ e, - e,
If e, and eu are independent and e, is randomly distributed
with a mean of zero, then
= 1, and
P, =-00
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 abandon-
ment 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 abandon-
ment value to something equal to or less than the original purchase
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 distri-
bution 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 assets operating risk could be completely
neutralized and its expected return maximized. The assets distri-
bution 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 because of the presence of legal,. moral and
ethical sanctions that exist to prohibit such behavior. Thus,
decision makers who are successful in hedging an assets business
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
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 repre-
sent 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(+
= rz( 1-2p)
and the variance and standard deviation would be,
VAR(rh) = 4rz p(l-p)
=2rZ /pm
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.
is 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
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 maxi-
mizing, 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 cases where p < .5 to cases in which p < .5. The range of possi-
bilities 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 puni-
tive damages (d) are a multiple of the actual damages suffered (ha).
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 return in 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.
Ngure 1
a0 = 0
/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 neutra-
lized and p were zero. If p 2 pe, then ou cue and /3, : PO. There-
fore, 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 business practices thus enables the firm to
acquire what would otherwise be an unprofitable asset. That is,
the combination of the assets expected return and risk can be
sufficiently altered to change the net present value (NPV) from
negative to positive. The firms security value and risk combina-
tion would reflect this acquisition.
It is not necessary for business risk to be completely neu-
tralized, 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 case outlined above, then, represents the 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; -Z PO is narrowed which
in turn means fewer opportunities to alter the NPVs of assets
through the use of unfair business practices.
The tradeoff of moral risk and business risk is a relevant
consideration only for insiders. The use of unfair business prac-
tices cannot be generally known to the market since this know-
ledge 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 know-
ledge 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 business risk.
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 firms securities
would be nominal or limited to the value of the asset(s) involved.
Summary and Conclusion
Normal business risk associated with any asset can be reduced
through various amounts and/or combinations of unfair business
practices. At the limit systematic risk can be completely neutra-
lized through this hedging process. An additional goal of the
hedging process, only tangentially considered in this discussion,
would be the enhancement of the assets expected returns. Neutra-
lization of business risk through hedging is only accomplished at
the expense of incurring the moral risk of disclosure and loss of
the assets return. Thus, the asset has only two states of the world,
a successful hedge and an unsuccessful hedge each with its respec-
tive probability. Figure 1 depicted a positive range of p in which
the moral risk incurred is less than the reduction in business risk
thereby making their sum less than the unhedged equivalent.
Assuming the assets expected return does not fall, the reduction
in risk produces an opportunity in which the risk-return combina-
tion is superior to that produced in an unhedged world. 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 associated with 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 adverse decision 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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