The Risk Profile

The basic tool for identifying and measuring a firm's exposure to financial risk is the risk profile. The risk profile is a plot showing the relationship between changes in the price of some good, service, or rate and changes in the value of the firm. Constructing a risk profile is conceptually very similar to performing a sensitivity analysis (described in Chapter 11).

To illustrate, consider an agricultural products company that has a large-scale wheat-farming operation. Because wheat prices can be very volatile, we might wish to investigate the firm's exposure to wheat price fluctuations, that is, its risk profile with regard to wheat prices. To do this, we plot changes in the value of the firm (AV) versus unexpected changes in wheat prices (APwheat). Figure 23.5 shows the result.

The risk profile in Figure 23.5 tells us two things. First, because the line slopes up, increases in wheat prices will increase the value of the firm. Because wheat is an output, this comes as no surprise. Second, because the line has a fairly steep slope, this firm has a significant exposure to wheat price fluctuations, and it may wish to take steps to reduce that exposure.

0 0

Post a comment