Discounting for risk

In trying to work out a strategy for e-business it is worth looking at the system that has evolved to deal with financial transactions because there are many parallels and similarities. Both have to deal with unpredictable environments that are too complex for logical analysis. But, how do the risk takers handle risks which defy any rational form of calculation?

The solution for investors and financiers lies in a technique they call discounting. It is best described by a scene taken from the CD-ROM "How God Makes God", where a family group are discussing the meaning of discounting. Here is their dialogue:

"Discounting is a term used in the world of finance. It is one of the most important concepts used in money and finance because discounting a price or value means allowing for risks."

"By discounting you reduce a price or value sufficient to allow for any risks involved."

"It sounds complicated, can you give us an example."

"Alright, imagine yourself to be walking along the road one day and a brand new Rolls Royce pulls up alongside you. The back window winds down and a wealthy looking old lady pops her head out. She apologises for stopping you in the street but explains that she and her chauffeur have inadvertently left home without any money. As it is now too late for the bank she wonders if you would lend her twenty dollars. In return, she offers to give you an I.O.U (I Owe You - a promissory note) for thirty dollars that her chauffeur will redeem first thing in the morning. Assuming you had twenty dollars, would you lend it to her?"

"I would probably lend the lady the twenty dollars."

"Now consider what you might do if it were a dirty old tramp that stops you in the street with this same proposition?"

"I think I would give him a few coins and quickly hurry away."

"Having loaned the old lady the twenty dollars and received her I.O.U, what value would that I.O.U. have?"

"Twenty dollars? That is what it would have cost me. Or, perhaps it ought to be thirty dollars because that is what I would get for it?

"Now what about the tramp's I.O.U.? Supposing you had given him the money, even if it had been out of pity, what value would you put on his I.O.U?

"Zero, I shouldn't expect to get the money back."

"Would you just throw it away then?"

"No. There's always a chance he'd pay me back"

"Would you sell it for five dollars then?"

"Yes. If I could find a buyer."

"Now then, supposing that when you arrived home you picked up the local newspaper and the headlines blazed a story about a confidence trickster who was operating in your area using an old lady and a stolen Rolls Royce. Also in the same paper is a story about an eccentric millionaire who is living like a tramp. What values would you now give to those I.O.U.s?"

"The values would be reversed. The old lady's I.O.U. would probably be worthless and the tramps would probably have full value."

"Would you throw away the old lady's I.O.U. then?"

"No I'd probably keep it - just in case."

"Would you sell it to me then?"

"If you gave me my twenty dollars back I would."

"Supposing I offered you one dollar?"

"I'd probably take it."

"Would you accept thirty guineas for the tramps I.O.U?"

"I wouldn't, he might turn up the next day and give me much more."

"Thirty five dollars then?"

"Yes, I'd accept that?"

"You can all see now how something might have a definite nominal value, but, the perceived worth can be quite different. Not only this, the perceived worth can change according to the risks associated with the real value. The perceived worth, therefore, is the nominal value discounted for various risks. Remember, also, the same apparent value might be perceived as a different worth to different people according to the information they possess."

This dialogue provides the essence of discounting. It is the adjustment made to a value to allow for the element of risk or change. Moreover, it tends to be subjective because every person may perceive the situation differently. It is this difference in perception that brings about variations in price and provides scope for profit.

Probability theory has a mathematical approach to discounting. It assigns a value to the probability of an event occurring. This value is a number between zero and one, such that it can be used as a multiplier to modify the value . If an event is certain to happen it will have a value of one. Thus, if you were certain that the old lady in the above example would repay the loan plus the interest, the I.O.U. would be perceived as being worth thirty dollars multiplied by one equals thirty dollars. If there was no chance of the I.O.U. being paid it's perceived value would be thirty dollars multiplied by zero equals zero.

Any element of doubt can be allowed for by using a value somewhere in between. If it were thought that there was a fifty-fifty chance of the old lady redeeming the I.O.U. then the multiplier would be given a value of a half (0.5), in which case the value of the I.O.U would be a half times thirty dollars - equals fifteen dollars. An estimate that the chances of the tramp redeeming the I.O.U might be one chance in one hundred (1% chance); this would see the perceived value of the I.O.U. reduced to thirty dollars multiplied by one hundreth - equals 30 cents.

As you can see, where there is an element of doubt or uncertainty, it can be allowed for by reducing the value according to the element of risk. The value is reduced in direct proportion to the risk. This is the fundamental basis of all financial and investment decision making.decision making.