Charles Brown writes:
"On the concept of being compensated for taking risk, how is risk defined ? Seems to me risk would mean doing something that has a 50/50 chance or less of succeeding. So, if all the rich were taking socalled risks in lending money, then overall the majority of rich people would lose their money and no longer be rich. But I believe most rich people remain rich, that is they dont lose their money in these socalled risks they take. So, we can look back and say that in fact they were not risking their money.. Therefore, they should not be compensated , because they didnt really take risks." If I put two bullets in a six chambered gun and asked you to play russian roulette, would you say that playing was not risky? I don't think your definition works. According to Wikipedia, "[i]n finance, risk is the probability that an investment's actual return will be different than expected." I would interpret that as follows. Assume that the time value of money is 3% per annum. In other words, (cetus paribus) $1.00 today has the same value as $1.03 next year, so (cetus paribus) I should be indifferent to whether I have $1.00 today or $1.03 next year. You want to borrow $1.00 from me today and promise to pay me $1.03 next year. I am agreeable to lending you the $1.00, but there is a risk that you will not pay back the $1.03, or will pay it late, etc. In other words, there is some probability (i.e. risk) that the investment's expected return (.03) will be different than what actually occurs. Therefore, to address that risk, I charge you more than 3% for the $1.00. The variable is a product of my due diligence of your proposed use of the money and my determination of the risks of nonpayment. If you are buying a house and I am secured by the house, my risk is a lot different than if you are investing in soybean futures on margin. I think your dicussion of how the financier is rewarded (i.e. compensated for risk) is distinct from the original question you asked, which is what "value" does the financier add. To repeat, the value added is that the financier is an integral process of determining whether capital should be devoted to project A as opposed to project B. That process plays itself out through a capital market defined by interest rates, etc., but the financier adds real value though due diligence, discretion, telling entrepeneurs their ideas are totally stupid, etc. David Shemano
