Allowance for risk

The investors and even the punters, have usually some Aversion with the risk . They prefer a relatively sure profit with a profit much more important but random (better is worth to receive 100 euros than to have a chance on ten to receive 1000 from them), according to the proverb “a bird in hand is worth two in a bush”.

Thus, there is a less keen demand for the risky things than for the nonrisky things. So the investors require in general to invest in a company (by the purchase of action S or any financial title emitted by companies) that the awaited output is higher than that of a nonrisky placement, i.e. that of the Government loans.

  • This difference in rate, this returned additional hoped for required , is the allowance for risk.
  • the rate corresponding, which is the sum of the nonrisky Taux and of the allowance for risk risky rate
is the

It is noted however that in period of great euphoria (Speculative bubble), the allowance for risk is even cancelled (Neutralité with the risk) becomes negative (research of the risk).

The aversion with the risk, which led to the concepts of Utilité and allowance for risk, is one of the very first concepts having been discovered in economy by Daniel Bernoulli, 300 years ago. However, the relevance of these concepts is the subject of various controversies nowadays, under the effect of research tasks related to the behavioral Finance.

The total allowance for risk of a given title can often be broken up in order to return account owing to the fact that certain risk factors affect all the companies of the same category whereas some another elements influence only one particular company. The total allowance for risk of a company has will be thus the sum of an allowance for risk of market (applicable to the other companies) and of an intrinsic allowance for risk (reflecting only the risk of the company A).

Examples

  • Diverses companies of Crédit proposes loans where it is not necessary to justify use of the money placed at the disposal. The rate practiced TEG is then often raised and reaches sometimes 20%! These companies indeed make a very important Marge on each credit but take the risk not to be refunded (Surendettement for example). Consequently, the Surprofit gained thanks to the people who refund their credit is used to finance the losses related to non-repayments (let us recall that these organizations do not create a currency, they buy it with the ECB ata certain rate and resell it ata higher rate with their customers).

  • the creators of Meetic took enormously risks, the current success not being at all foreseeable. The taking risk was well remunerated (by the Profit and the increase in value of the Entreprise). If they had failed, they would have had a remuneration of - 100% (i.e. the loss of all the funded capital).

We can make the calculation of the hope mathematics of the following profit, where K \, accounts for the funded capital, 300% the assured profit if the bet is won, p \, the probability that the project succeeds and q \, the probability that the project fails.

E = \ times K \ times p + \ times K \ times Q \,

The company takes a risk, it thus has an allowance for risk which is here of 300%.

For the purists, we note obviously that p = 1 - Q \, , because either the project succeeds, or it fails (cf Bernoulli); to simplify the thing, we do not plan an intermediate solution (like a " small succès"). To concretize the thing, we can suppose that p = 0,3 \, (30% of chance that the project leads on a success). Thus, the hope of the profit is of 3 \ times K \ times 0,3 - 1 \ times K \ times 0,7 = 0,2 K \, , is a hoped profit of 20% (thus mathematically, it should be taken this risk since it is much higher than the nonrisky rate).

Foot-note

A more rudimentary method consists in calculating an allowance for risk " instantanée" , and not futurology based on the anticipation of future incomes. It with the form of a simple subtraction between
  • the " output bénéficiaire" (opposite of PER) on the current stock exchanges of the Market index
  • and the current rate of market of the government bonds at 10 years.
In spite of its side rather not very significant, it is often used in the financial press to simplify calculation and to avoid the risks of the anticipation of the profits.

See too

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