Risk Homeostasis and Mergers and Acquisitions*

The idea of adjusting behavior to maintain risk is known as “risk homeostasis. ” This paper considers the implications of this idea in the context of mergers and acquisitions (M&As). Using a sample of M&As over 1980-2007, we first show that when bidders ’ risks happen to decline relative to industry- and size-matching non-bidding peer firms prior to an M&A, relative risk levels subsequently return towards original levels. We argue that this pattern is consistent with risk homeostasis whereby the bidder has a preferred level of risk—the risk of its peer. We then develop a simple model of risk homeostasis in the context of M&As. The main predictions of our model are: when a bidder’s relative risk declines, the greater is the risk of a target firm, the smaller is the investment in that target; and for a target firm smaller than the bidder, the larger is the correlation between the target and the bidder returns, the smaller is the investment in that target. Evidence from risk dynamics and results from multiple regressions provide support for a risk homeostasis perspective on M&As