- Let's talk about risk.
First, what is risk?
Risk is uncertainty about what will happen in the future.
In the future, there will be variability
as to possible outcomes.
We make an investment in a product, we hire a key person,
we build a building, it could go well, it could go poorly.
Variability in potential outcomes is what we call risk.
Consider a commercial real estate investment.
I can build a commercial real estate building,
and rent it out to tenants.
The building can be in the heart of the business district,
where there are many potential tenants.
I'm pretty confident,
that I'll be able to rent space in that building.
On the other hand, let's suppose I'm considering building
a commercial building in an industrial park,
at the edge of town.
And when I say the edge of town,
I mean it's out there where nobody is there yet,
there're weeds on the lot.
Tenants may come or not, I'm not sure.
There's much more risk, much more variability
in potential outcomes out there on the edge of town.
There are many different kinds of business risk.
Here are five.
Price risk, credit risk, interest rate risk,
exchange rate risk, and cash flow risk.
Let's talk briefly about each one of these.
Price risk is the uncertainty
about the future price of an asset.
Let's say I'm going to buy inventory in the future.
Will the price go up, or will it go down?
Credit risk is the uncertainty
that the party on the other side of an agreement,
will abide by the terms of the agreement.
I make a sale on credit to a customer.
Will they pay or not?
There's a slight chance they won't pay, that's credit risk.
Interest rate risk is the uncertainty,
about future interest rates
and their impact on my cash flows.
For example, let's suppose
I have a variable interest rate loan, rates go up or down.
If the rate goes up in the future,
that's going to require increased payments,
and more cash outflow for me.
Exchange rate risk is the uncertainty about fair values
and future cash flows arising, when assets and liabilities
are denominated in a foreign currency.
Let's suppose I have a receivable from a company in France.
The receivable is denominated in euros.
Because the receivable is denominated in euros,
and if I plan to convert those euros into U.S. dollars,
I'm not sure how many U.S. dollars,
I will receive in the future.
Cash flow risk, is the uncertainty about the amount of cash
that's going to be generated or consumed in the future,
based on decisions that I make today.
I buy a piece of equipment, assuming it's going to generate
cost savings in the future.
But I'm not sure what those cost savings are going to be.
That's cash flow risk.
Insurance companies exist because of risk.
It's their job to take risk from me,
and assume it themselves, and I'll pay them for that.
So there are many different types of risks
associated with businesses, and there are companies
that will help me mitigate those risks.