Risk Homeostasis and Corporate Acquisitions

Adjustment of behavior to maintain risk, known as risk homeostasis, has previously been studied in a variety of psychological, health, social and economic contexts. This paper examines the evidence for risk homeostasis in corporate financial decisions involving mergers and acquisitions (M&As). We first show that when bidder corporations' risks decline relative to non-bidding peer firms prior to M&As, relative risk levels subsequently return to original levels. We argue this pattern is consistent with risk homeostasis whereby bidder companies have a target risk — that of their peers — and use M&As to regain this desired risk level after risk has declined. On the other hand, M&As are not used to reduce risk after it has increased. We develop a simple model of risk homeostasis in an acquisitions context, and find empirical support for our predictions: when a bidder's relative risk declines, the greater the risk of a target, the smaller is the investment in that target; and for a target firm smaller than the bidder, the larger the correlation between the target and the bidder returns, the smaller is investment in that target