Risk is defined as the difference between the expected and the actual returns earned by a company. Like companies, for individuals too, expected and actual returns are different. The risk is created either by individual-specific variables, or by variables that are common to everyone residing in a certain place. The former is called unsystematic or diversifiable risk and the latter, systematic or non-diversifiable risk.
Beta is used to measure the systematic or non-diversifiable or common risk of companies when one attempts to value the intrinsic worth of the business. This is based on the premise that only systematic risk adds premium to the company?s risk as all other risks are diversifiable through proper portfolio construction and execution.
Personal risk premium: If beta is considered as the measure of common risk, the common/market risk faced by an individual can be called personal beta. But it is difficult to measure the risk of an individual using the market beta calculation as individuals are not traded in the markets.
The method of computing the bottom-up beta (for companies without market data), using the data of comparable traded companies, is not feasible in case of individuals as they are not traded in the markets.
Lending institutions cannot treat all individuals at the same level of risk exposure and, hence, need to compute personal risk premium. This premium can be added to the risk-free rate to arrive at the cost of equity. Similarly, the intuitive base of arriving at the rate of interest is to add premium to the rate at which the banks lend to their most favourable customers.
Determinants
Nature of revenue stream: If an individual is salaried, his revenue stream is more regular than that of, say, Vineet Paneendra, an entrepreneur. If a person has a permanent job in a government organisation, his revenue stream is relatively better compared to someone in a private entity on a contract basis.
If the revenue stream is regular, the premium to be added to the base rate is lower; and if the revenue stream is subject to uncertainty, the premium should be higher. If the individual is an entrepreneur and his business deals with discretionary or non-essential products, the premium should be higher. Similarly, if a person is working for a company facing a financial crisis, he should be assigned a higher risk premium.
Level of operating leverage: Operating leverage describes the impact of fixed cost on the income of companies. Operating leverage can be measured by dividing the fixed cost of the companies by their total cost. Higher the number, the higher is the risk. For instance, fixed cost as a percentage of total cost for Paneendra is 70% against the industry average of 50%. This means he is relatively riskier. That is, if the revenue is going to drop by, say 20%, the impact would be higher (see graphic). The revenue is coming down by 20%, but the profit before tax comes down by 62%. Such a huge drop in the PBT is basically caused by the operating lever or fixed cost structure of Paneendra.
Level of borrowing: An individual with a higher debt-to-equity ratio or debt-to-capital ratio should be given a higher premium compared to another individual with a lower ratio. Higher the borrowing, the higher is the bankruptcy cost.
How to develop premium for risk: One simple way to estimate the total risk premium is to arrive at a weighted score. Based on the total score obtained by the borrower, the premium can be assigned to the individual for his default risk. For instance, if Paneendra gets a total score of 2+3+5=10 (= average of 3.33), then 7% can be added to the interest rate charged for the most favourably rated customer.
* The author teaches accounting & finance courses at IIM Ranchi