Abstract:

The management of risk is important in financial institutions. In particular, investment houses dealing with volatile financial markets such as foreign exchange or government bonds may find it difficult ot maintain "proper" levels of risk taking. On one hand, firms encourage traders to take risks in trading government bonds, but on the other, they promote risk aversion since they value reputation as careful and solid investors rather than having a reputation of risk takers. Government bond traders work in a very volatile and fast moving market. They are compensated by a base salary plus a bonus which relates to the profit and loss (P&L) they create for the firm on the securities they trade. Recent models of risk taking (Kahneman and Tversky, 1979; March and Shapira, 1992; Shapira, 1995) suggest that risk taking is affected by the targets or reference points that people use to evaluate risky prospects. Such targets can be set by "objective" grounds, that is, based on some rational economic considerations of profitability. However, often the targets are set in a "comparative" sense, that is, by comparison to the performance of other similar firms. The above models suggest some alternative ways in which targets may affect risk taking. These predictions are tested using data on actual purchase and sell decision made by government bond traders. Implications for risk management are discussed.

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