Time Value of Money and Risk

I’ve talked about the time value of money and how this is probably more appropriately called the value of productivity. That is something things are valuable in virtue of the valuable things they produce. TVM is an attempt to value the productive thing in terms of the value of what is produces.

Now, the question of risk comes into play. It is often said that because of such and such a risk an investor will require a greater return. This is a purely subjective understanding which we are attempting to avoid or at least ground in reality. It is true that investors will demand a greater return, but why is this.

Consider two chainsaws. One produces five logs of wood 100% of the time. One produces five logs of wood only 50% of the time. Clearly, the second chainsaw is worth less than the first in virtue of the uncertainty of the production. This uncertainty is a sort of risk taken with the chainsaw because is has some chance of failing and it is for this reason that it is worthless. For whatever reason it is defective compared to the first.

We see this in TVM or something like a capital pricing model, where riskier assets have a higher rate of return. It is because they are really worth less, because of the degree of defect that makes them more risky.

Therefore, in order for a defective chainsaw to be as valuable as a non-defective one, it must promise a greater possible production. It promises ten logs 50% of the time, which brings the average to be the same.

This is just a beginning to understanding a required return. And there is still more to say about this. Perhaps looking into something like the CAPM with a realist lens would be valuable.

As a point of pure speculation, it is wonder what the risk-free rate would indicate in a realism. I suspect it has something to do with the reality that all material things, even the best, are defective in some way and perhaps this is related to the systematic risk that cannot be diversified in the market.

EDIT:

Starting with a model like CAPM is a bad idea. We are interested in what can be known with certainty. CAPM and any model that attempts to quantify the value of a risky asset has numerous (probably ambiguous and bad) assumptions.

What we can know for certain is that risky assets are defective in some way. It is in virtue of this defect that they are considered risky. It is in virtue of this defect that the asset is objectively worth less than a less defective asset all else being equal.

It is also certain that there is no such thing as a risk-free asset. All material things are defective in some way, have some change of failure and are more or less likely to breakdown over time.

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One Response to Time Value of Money and Risk

  1. Pingback: Objective Value of Contracts | Infinite Semiosis

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