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Being Business Focused: Risk

‘Being Business Focused’ is going to explore various business concepts and how we can use them to explain the bottom line impact of our decisions.

Don’t forget we learned roi = (fv-iv)/iv

Now I want to talk about another fundamental concept at the bank and how it can affect overall ROI. Today’s word is ‘Risk’. In the world of finance risk has a very real and measurable impact. You can see that impact very easily in the interest rates charged for loans. The riskier the loan the higher the interest rate. There is a financial model that we can use to discuss the different elements of risk and its impact on the cost of financing a project. The specific one I want to talk about is the ‘Capital Asset Pricing Model’ (CAPM). I like this model because it is simple and demonstrates a few things that I think are interesting about risk.

Ok, so what is CAPM? CAPM states that the expected return (Ri) is equal to the risk free rate (Rf) plus the beta coefficient (Beta) multiplied by the risk premium, where the risk premium is the market risk rate (Rm) minus the risk free rate.

Ri = Rf + Beta*(Rm - Rf)

So what does all that mean? Risk free price/rate is the price for the THING if there is no risk involved. The market price/rate is the price for the THING on the street, this price is usually higher than the risk free rate because it includes a ‘premium’ to account for the risk involved, ie “You mean I might lose my money, then I want a bigger payout!” The beta coefficient I can only explain as the volatility in the market, if the market is making wild swings then any risk you take will be magnified by it and therefore affects the expected return.

This next section is not entirely accurate and is used only to show how playing with the risk levers can change the ROI. NOTE: You probably won’t use the model directly, but understanding the different components of this model has been helpful for me when talking to the business.

When we start to talk about buying and selling money, my brain starts to hurt. I am going to buy money…with money? owwwww… What I have noticed is that the smart guys with the finance knowledge talk about the price of money as the rate that you borrow it at, the money borrowed is called capital, and the CAPM helps us analyze the rate. To show its impact on ROI I am going to substitute it for the initial value since it kinda represents the price we borrow money at.

WARNING: Dru is getting jiggy with the math

roi = (fv - capm)/capm

Now that we have a game plan, lets plug some numbers into CAPM and see what happens. In the financial world government bonds tend to be the benchmark of risk free money, so lets say that gov bonds are going for 0.05, and the same bond offered by your company is going for 0.07 (these are totally made up numbers), and for the beta lets assume a 1 (so that we can ignore it for now, hit me up on email for more info).

0.05 + 1 * (0.07-0.05)
0.05 + 1 * 0.02
0.05 + 0.02
0.7

We can see now that we have a risk premium of 0.02, and that if we can find a way to reduce that risk premium it will have a direct affect on our ROI calculation above. Like the financial world anything we do to try and reduce risk is going to cost us something, so its nice to know that your cost (increase initial value) of the mitigation is less than its return (future value). Let’s say that something happens and we can now offer that same bond at 0.06, with negligible impact on initial value.

0.05 + 1 * (0.06-0.05)
0.05 + 1 * 0.01
0.05 + 0.01
0.06

So we see the price lowered. Not a big surprise since we were able to magically lower it, but we did it by targeting the risk premium and we can now see its impacts on ROI. By lowering CAPM in our ROI calculation we have increased ROI (lowering the bottom number and increasing the top number).

Before

roi = (x - 0.07)/0.07

After

roi = (x - 0.06)/0.06

Ok, so what are some examples of developers lowering risk? As developers we do many things to reduce risk in our projects. I know one thing that I like to do is put the risky parts of my code base behind an interface. That way I contain the risk of that section to just that section. In financial terms I am limiting my exposure to the risk. Maybe the risk is that the business hasn’t decided something, like which payment gateway to use. When building a system that kind of unknown brings an implementation risk to the project, but we can effectively nullify a large chunk of that by simply coding against an interface that we will implement once the business has decided.

So what is the take away? Lowering risk can lower your effective initial investment, which will then increase your return on investment.

I hope that you find this helpful

-d

About Dru Sellers

Sr. Software Engineer at Dovetail Software.
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  • http://codebetter.com/members/sross07/default.aspx sross07

    great series. Keep it up. As a current developer and someone who is pursuing my milr, this is a great look at why decisions are made by development teams/organizations.

    thank you.

    Sr

  • http://www.codebucket.org Lee Brandt

    Dru:

    Great series so far. Very interesting. Keep em coming.

    ~Lee