Unraveling Risk Appetite: applications of decision theory in the evaluation of organizational risk appetite

In our current era of major global challenges and worldwide crises the human race is continuously searching for solutions to the fundamental economic problem of how to determine which aims should be pursued and how limited resources ought to be allocated. Economics as the science that studies “human behavior as a relationship between ends and scarce means” (Robbins 1932 p.16) is poised to prescribe normative antidotes to the calamities and acts of man that plague today’s financial and economic markets. Aiming to minimize the adverse effects of risk at minimum cost, organizations are engaged in a balancing act between the ex ante allocation of resources for risk reduction and the ex post adequacy of resources to absorb losses. The outcome of this trade-off is an expression of the organization’s willingness to accept risk, also known as its risk appetite. Scarcity of resources implies that the probability of occurrence and the potential impact of events identified as risks cannot always be reduced beforehand, and thus requires these risks to be ranked in priority by a decision maker in the organization. Risk attitude, a concept from decision theory, allows one to specify the rank order of a set of identified risks. In addition, the concept of risk appetite specifies the subset of this rank ordered set of risky events that requires control measures and its complement that, in contrast, is accepted. Given that organizational risk appetite is not unlimited, this thesis explores how measurements of risk attitude can be applied meaningfully in risk management to the economic problem of scarcity of resources.

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