Economics Finance

Calculating the True Cost of Risk


On Dec 5 the Wall St Journal ran an an interesting piece about an attempt by some academics to calculate the cost to the economy of the uncertainty in government policy. As the Journal notes:

With the election over, the focus is back on figuring out just how much uncertainty actually hurts an economy. It could lead consumers to save more and spend less. It could deter already-wary executives from taking risks. And by making investors uneasy, uncertainty could make financing more costly for companies.

The professors in question, Steven Davis of the University of Chicago and Scott Baker and Nicholas Bloom of Stanford, are trying to do something I discuss with clients and students all the time, namely, trying to convert an economic risk cost into a financial risk cost. What does that mean? Well, let’s start by stating a fundamental aspect of risk that many people do not understand: in its purest sense, risk is a cost created by uncertainty. The example I use with students to illustrate this point is to show them a white envelop in which I say there is a 100% chance that it contains a $100 bill and then ask them how much they would be willing to pay for that envelope (assuming for a moment they prefer a single pill to $100 worth of coins and singles in their pocket). The answer, of course, is $100. But then I say that I will “add risk to the envelope” and tell them now there is a 50% of the $100 and 50% chance of $0. Now how much would they pay? The answer is $50, naturally. Presto: by adding risk (i.e., moving from one potential outcome to two of unequal value), I reduced the market value of the envelope by 50%.

Now, there is no doubt in my mind that any volatility in government policy vis-a-vis fiscal policy or regulation creates a cost. The issue, as the researchers know, is that cost is what I call an “economic cost” and by that I mean that the cost is borne but not accounted. Examples of economic risk costs in business are reputational risk or often weather risk. The other type of risk cost is a financial risk cost, and this is one that (a) has been valued financially or (b) whose impact was recorded in a company’s financial systems and statements, for example insurance payments or excess inventory build up ahead of a storm.

One reason why risk is hard to deal with in many companies is that executives may intuitively know they are bearing very high economic risk costs but are unable to calculate their financial value, which is the first step toward managing the risk. [As an aside, if risk is a cost, then risk management is simply the reduction of the cost of risk, but more on that in a later post]. In essence this is exactly what the researchers in the WSJ piece are trying to do, and it is a valuable if difficult effort. If more Americans were aware of the financial cost of government disfunction and uncertainty, perhaps those aspects of our society would not be so acceptable.

WSJ subscribers can read the full piece here:

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