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Thursday, February 9, 2012

Risk Appetite

It is the capacity of an organization or an individual to take risks in return for profits. For an individual, this could be the willingness to invest in equities in a falling market in the hope of picking up a bargain. For an organization, it could mean cutting the price of its products to gain market share at the risk of lowering its brand value.

What Are The General Assumptions While Taking Risks?    

Economic and financial theory assumes that generally investors are risk averse, which means that all investors prefer lesser risk given a certain amount of return. Alternatively, they would like the highest possible return given a certain amount of risk. This means among two equally risky investments an investor will opt for one that gives a higher return or he will opt for less risky investment if the returns are equal.

Is It Possible To Quantify It?    

It is difficult to put a value to risk appetite, but in relative terms it is possible to say whether someone has a higher or lower risk appetite than the other or with a reference to a period. However, it may be possible to put a quantitative limit on some risks, such as capital adequacy ratio, sectoral caps on investments, and over-investment in some sectors.

What Are The Determinants Of Risk Appetite?    

It is generally determined by factors such as goals of investors or organisations, amount of reserves, wealth or savings, changing global environment and needs of stakeholders. A person or organization that is secure from various threats has, in general, a higher risk appetite. In a difficult economic environment risk appetite tends to decline.

What Does A Decline In Risk Appetite Mean?    

A decline means tighter control on spending and investments. This leads to funds moving out of risky assets and discourages investments as agents tend to hold on to cash and safer assets. The overall effect is that economic activity drops.
 

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