200 words for each question, number answers accordingly
F1a. Risk tolerance for companies is driven by the return rate. The company sets the required return rate and develops investment strategy to meet that return rate. This is the case for speculative risk. For pure risk, risk tolerance is driven by costs. If the potential for loss is greater than the cost of the risk mitigation program then the company will pay the cost of risk mitigation. This is the case for insurance. Do we take on the cost of insurance premiums to mitigate our potential risk? Whether this cost is a transfer cost or hedge or other risk mitigation plan. It is important to understand that risk tolerance is choice driven by different factors whether business or individual.
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Is there any psychology to this? What are the environmental factors? What mitigation plans can you think of for pure risk? How does that help the risk averse? What examples can you think of that support these statements?
F1b. If we consider risk tolerance as a position, we can look at factors involved in determining risk. For example if we purchase a boat we may want to insure it. Especially if we are risk adverse. However consider the difference in return. If I have insurance on the boat, I may never make a claim. Thus it is only a cost to me. Even if I were to have a claim, but it is less than the premium, I would have just cost. Now if I chose not to have insurance I could save the cost of the premium but I would not have the protection from a higher than premium. This is the basics of risk adverse.
Investment risk is the difference in return between two or more investments or the profit or loss on a single investment. In investment it is more about opportunity profit or loss then as in insurance about the protection of accidental loss. Through pool risk we can reduce our exposure and uncertainty. What examples can we present? Anyone?
F1c. we can tie risk aversion, valuation and insurance together. Risk aversion is driven by wealth. Those that are risk averse do not want to reduce or risk reducing their wealth. The more value you have to lose the more insurance risk averse generally has. The risk adverse individual will have insurance to protect their wealth up to the cost of the premium that spends the wealth. Consider the individual that insures a boat. They will pay premiums up to the value of the boat to protect its value. As soon as the premiums exceed the value it is no longer worth to the risk averse the hedge against the loss of the asset.
There are a number of factors that drive risk tolerance. It is these factors that we can use to measure risk tolerance. Besides age what other factors drive individual investors, can someone list them? Further this is fine for individuals but what about corporations. What factors do we need to consider for corporations, can you list some? Are they the same? Can they be measured? In what way can we create a risk program if we know the factors involve and what our risk tolerances are? Thoughts anyone?
F2a. Keown, Marin, and Petty (2008, p. 212), described valuation as:
It is assigning value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate. The investor’s required rate of return, k, is determined by the level of the risk-free rate of interest and risk premium that the investor feels is necessary compensation.
This is the basic concept to evaluation. By knowing and understanding the value of an asset help to understand the risk associated to it. From there we can determine our approach to controlling the risk around that asset. How does this help with risk management? What examples come to mind that describe this?
Keown, A. J., Marin, J. D., & Petty, J. W. (2008). Foundation Of Finance. The Logic and Practice of Financial Management (6th ed.). Upper Saddle River, NJ: Prentice Hall, Inc.
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