The Risk/Return thinking

Non-finance colleagues may treat risk from a negative angle and seek to eradicate all aspects of it. That’s easy (for them). However, shareholders invest to take risk and it would be improper to eliminate it. A risk manager by using his knowledge of risk and how to manage and evaluate it in the markets, can support and lead the company through the thinking required to make rational decisions.
The thinking that risk manager can impact on many business situations is helpful (in many cases is critical) in evaluating and solving a business issue. Particularly where different types of business are being evaluated against each other (i.e. the development of new products versus the extension of existing lines or the movement into new business areas versus organic growth of the core business).
There is a classical approach to this problem. An increase of the discount factor used in the new product or new business discounted cashflow. However, this does not add much value or insight to the business analysis.
A more businesslike approach is required to support the thinking of the business in an area where there will usually be no clear-cut solution.
In every case, the first step will be to identify and understand the risks involved in a project.
Consideration of whether (irrespective of potential returns generated) the amount of risk would be acceptable, or can be mitigated or insured, will need to made at an early stage.
Assuming the risks can be managed,  a method is required to evaluate whether adequate returns are being obtained for the risk being taken.
For risks with a simple normal distribution around a mean, the use of an ‘expected’ discounted cashflows or a modified cost of capital might be appropriate.
For high-value remote risks (i.e. potential rise of high-cost litigations) then an actuarial or insurance-based approach might be required.
For risks with only a few outcomes, a derivatives-based approach could be used.  


Did you like this article?
Subscribe to ReplayBusiness to receive all new postings straight to your inbox!

Tell us what you think!
We truly encourage your participation!
Contact us:  http://www.replaybusiness.com/p/contact.html

This is how we all learn, share and acquire knowledge!

Twitter
Follow us and retweet to your followers: https://twitter.com/ReplayBusiness
 
Replay Business © 2011 Costas Stabolas| Designed by Nowmysite.com