David S.:
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. ^^^^^ CB: Good point. But to make the analogy fuller, I think the result of shooting the gun on the empty cylinders would have to have the effect of extending your lifetime by 100 years or something like that. You'd have a four out of six chance of living 100 years longer and a two out of six chance of dying immediately. ^^^^ According to Wikipedia, "[i]n finance, risk is the probability that an investment's actual return will be different than expected." ^^^^^ CB: Why should someone be compensated for taking such a "risk" ? ^^^^^ 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. ^^^^^ CB: Why does the value of money grow over time ? What new wealth does money produce by just existing ? ^^^^^ 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. ^^^^^ CB: If your money is secured by the house, why are you taking any risk at all ? ^^^^^ 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. ^^^^^ CB: So, they are compensated for advice , not for the loan of money ?
