Present value and Risk: Difference between pages

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(PV).  
1. ''Corporate finance.''


Today’s fair value of a future cash flow, calculated by discounting the future cash flow at the appropriately risk adjusted current market [[cost of capital]].
In the corporate finance context, risk refers to the degree to which future returns may vary.


Risk is often measured by the standard deviation of forecast returns. 


For example, if $110m is receivable one year from now, and the cost of capital (r) is 10% per year, the Present value is:
It is often estimated by the standard deviation of <u>historic</u> returns, though this process is inherently error-prone when used for <u>forecasting</u> or for risk management purposes.


PV = $110m x 1.1<sup>-1</sup>


= $100m.
2. ''Capital asset pricing model.''


In the Capital Asset Pricing Model, relevant risk is measured by beta.


And more generally:


PV = [[Future value]] x [[Discount factor]] (DF)
3. ''Unknown occurrences.''


Where:
In a more general sense, risk refers to the unknown (or unknowable) nature of future outcomes involving, for example, market prices or market rates.


DF = (1+r)<sup>-n</sup>


r = cost of capital per period; ''and''
4. ''Adverse effects.''


n = number of periods
Risk can also refer to the possibility of <u>adverse effects</u> resulting from:


- Changes in market prices or rates, or


'''''Examples'''''
- Changes in other general conditions in the market, or


For example, if $10m is receivable one year from now, and the cost of capital (r) is 6% per year, the Present value is:
- Other economic factors specific to the business or other organisation (such as the failure of a key supplier).


PV = $10m x 1.06<sup>-1</sup>


= '''$9.43m'''.
5. ''Opportunity and hazard.''


More broadly, risk can refer to the possibility of any event occurring that will have an impact on the achievement of objectives.


This includes both the upside opportunity and the downside hazard which could either move us towards or drive us away from achieving our objectives.


Now changing the timing in this example, if exactly the same amount of $10m is receivable but later, namely two years from now, and the cost of capital (r) is still 6% per year, the Present value falls to:
Risk in this context is measured both in terms of (1) its impact and (2) its likelihood.


PV = $10m x 1.06<sup>-2</sup>


= '''$8.90m'''.
'''Treasury's role in risk management'''


No organisation can eliminate all risk, so risk has to be managed effectively. This is best done through a risk-aware culture.


The longer the time lag before we receive our money, the less valuable the promise is today.
Generally, treasury is about managing risk rather than taking risks.


This is reflected in the lower Present value for the two years maturity cash flow of $8.90m, compared with $9.43m Present value for the cash flow receivable after only one year's delay.
Many risks should be managed. Risk management is a key activity of the treasury function.




== See also ==
== See also ==
* [[Adjusted present value]]
* [[Alienation of assets]]
* [[Compounding factor]]
* [[Beta]]
* [[Discount factor]]
* [[Black swan]]
* [[Annuity factor]]
* [[Capital asset pricing model]]
* [[Discounted cash flow]]
* [[Capital risk]]
* [[Future value]]
* [[Commercial credit risk]]
* [[Intrinsic value]]
* [[Commodity risk]]
* [[Net present value]]
* [[Counterparty risk]]
* [[Profitability index]]
* [[Default]]
* [[Terminal value]]
* [[Delivery risk]]
* [[Time value of money]]
* [[Diversification]]
* [[Downside risk]]
* [[Effective annual rate]]
* [[Financial market risk]]
* [[Financial market price risk]]
* [[Financial risk]]
* [[Guide to risk management]]
* [[Insurance]]
* [[Legal risk]]
* [[Market risk]]
* [[Market price risk]]
* [[Model risk]]
* [[Regulatory risk]]
* [[Return]]
* [[Risk averse]]
* [[Risk management]]
* [[Standard deviation]]
* [[Tax risk]]
* [[Transfer risk]]
* [[Treasury]]
 
[[Category:Risk_frameworks]]

Revision as of 14:32, 8 April 2021

1. Corporate finance.

In the corporate finance context, risk refers to the degree to which future returns may vary.

Risk is often measured by the standard deviation of forecast returns.

It is often estimated by the standard deviation of historic returns, though this process is inherently error-prone when used for forecasting or for risk management purposes.


2. Capital asset pricing model.

In the Capital Asset Pricing Model, relevant risk is measured by beta.


3. Unknown occurrences.

In a more general sense, risk refers to the unknown (or unknowable) nature of future outcomes involving, for example, market prices or market rates.


4. Adverse effects.

Risk can also refer to the possibility of adverse effects resulting from:

- Changes in market prices or rates, or

- Changes in other general conditions in the market, or

- Other economic factors specific to the business or other organisation (such as the failure of a key supplier).


5. Opportunity and hazard.

More broadly, risk can refer to the possibility of any event occurring that will have an impact on the achievement of objectives.

This includes both the upside opportunity and the downside hazard which could either move us towards or drive us away from achieving our objectives.

Risk in this context is measured both in terms of (1) its impact and (2) its likelihood.


Treasury's role in risk management

No organisation can eliminate all risk, so risk has to be managed effectively. This is best done through a risk-aware culture.

Generally, treasury is about managing risk rather than taking risks.

Many risks should be managed. Risk management is a key activity of the treasury function.


See also

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