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Why do companies need to understand risk?

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” (Nocera, 2009). Against this backdrop, I commence my discussion regarding the importance of understanding the nature of risk, and its profound effect on the returns of long and short term investments undertaken by businesses. The thought of escaping risk is an impossible feat. As with every action, there is an attached element of risk to it; ‘avoiding risk can itself be risky’ (Salzberg, 2010). Effectively, to survive and achieve growth, a business must learn to embrace risk by understanding its intricate elements, and the impact it brings about its operations. Thus risk, if handled properly, may very well be a source of opportunity. The Chinese captured such a concept, by denoting the symbol for risk as “a combination of two symbols—one for danger and one for opportunity (Damodaran, 2005).

What is risk? Though there is no verdict on an exact definition, Elroy Dimson proposed a rather interesting version, which states that “risk means more things can happen than will happen” (Farrell, 2007). So in that sense, risk is the anticipation of future events that will have an adversary effect on a given business; though not all events will take place. Also, not all events can be anticipated. If we can foretell the future, the element of risk would simply diminish to zero. Thus, risk is our interpretation of how the future events will unfold, given the current factors we have at hand.

From an Investment’s point of view, taking on risk will result in some form of return. How high or low the return is depends on how the predicted risk element pans out with the actual future events. Nonetheless, a return is composed of two elements: an expected part and a ‘surprise’ (Ross et. al, 2008, p.322) part. The expected part further breaks into a:
– Systematic element: a surprise element that is applicable to almost every asset
– Unsystematic element: a surprise element applicable only to a single asset

As companies go about their everyday business, they constantly engage with various activities; each having an element of risk. And as discussed earlier, each risk has a return associated to it. Thus, as companies go about their daily business, they are maintaining a portfolio of returns:
-> They must achieve a certain return to shareholders
-> They might have invested in other companies (thus they expect a certain return)
-> They might be undertaking a project (thus they need to achieve a certain return margin for the project to be profitable)
…etc
So for companies to survive, they must understand risk (the systematic and unsystematic elements), as this affects the returns generated, and would, in turn, affect the company’s return/investment portfolio on the short and long runs.

In understanding systematic risk, I bring upon an example from the company I currently work for. I work in a financing house in Saudi Arabia. Though it is a privately held company, they are constantly engaged in loan extending transactions, which bears an element of risk. The rates that are offered to the clients’ partly accounts for the systematic risk element [though it cannot be predicted precisely]. Examples include:
-> The prevailing SIBOR in the Kingdom
-> The death of King Fahd in 2005: “the market opened at a decline” (Akeel, 2005), which resonated across the whole Saudi economy, resulting in our company receiving delayed payments from its clients, and a lower overall return.
-> During the end of 2008 and throughout 2009, bearing in mind the global crisis, the oil prices fluctuated from “$98 per barrel, rose to $147 per barrel in July, then ended the year at $44 per barrel” (Anon, 2010). Such swings had an effect on government spending (especially in the early part of 2009), and effectively also affected client payments to our company.

Now, in understanding unsystematic risk, we continue upon the example of my company. Unsystematic risk examples include:
-> The change of our General Manager – the older one suddenly decided to resign. As the new GM is not tested [came from outside], this raised the risk factor to the company’s owners, thus requiring higher returns (meaning a higher cost of capital on our company) [short-term issue]
-> Changes in the leasing laws, as per directions from the Saudi Arabian Monetary Agency. This drove up the cost of doing certain parts of our business [short-term issue]
-> A conflict of interest issue, which required us to create two operational units (instead of one), and essentially drove the prices up [long-term issue]

Thus, in order to continue surviving, the company must understand how these systematic/unsystematic risks affect it – whether they are long or short term in nature. Once it understands, it will be able to minimize its risks [i.e. maximize its returns]. Also, by understanding how the various risks impacting the company and its effect on its overall returns [from current projects], they will be able to determine whether or not to “add a new project to its existing portfolio… [By] estimating the coefficient of correlation between the cash flows [returns] from the new project and the total cash flows [returns] from existing projects … it can [thus] determine the effect of the new project on the means and standard deviations of the total cash flows” (Hull, 1986) and decide on its overall benefit to the portfolio.

Understanding how risk [its systematic and unsystematic elements] impacts a company’s activities is of crucial importance to its survival in the short/long term. Failing to comprehend and incorporate such risk elements in business activity will lead to catastrophic results. Referring to the 2008/2009 global economic meltdown would suffice.

~ Youssef Aboul-Naja

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  1. Anonymous
    February 22, 2010 at 9:08 PM

    This goes far beyond trade & industry as it is binding to all human actions and reactions.

    -“…understanding the nature of risk, and its profound effect on the returns of long and short term ((desires/aspirations))…”

    -“…to survive and achieve ((in general)), one must learn to embrace risk by understanding its intricate elements, and the impact it brings about.”

    **IF HANDLED PROPERLY (this is the key), risk paves the road to our long & short term aim/target and this goal becomes an acheivement**

  2. March 4, 2010 at 6:21 PM

    Nice one bro..Keep it up!

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