The ability of investment to produce future returns is fraught with probabilities. The alternative chosen for use of an asset is a matter of deliberation and discretion. It should therefore be possible to value an investment based on the risk-taking nature of the group that controls deployment of the asset. The matter is worth pursuing wherever there is value in predicting future cash flows from an investment, and when the past is known to be of low relevance for conditions in the future. It is also of interest because it could allow for the professional application of modeling to an area of widespread interest and concern amongst all communities of investors.
Though a quantile approach can ameliorate the confusing scatter of past events with respect to independent variables, major qualitative changes in their complex inter-relationships can result in the most disruptive discontinuities as we extend past trends in to horizons of the future. There are situations in which statistical validity is inadequate for a decision on a risk with very serious consequences. We need, as far as possible, to create comprehensive scenarios in which the outcome can be reasonably guaranteed if specified conditions are met. The imperatives of a risk management approach will not allow for the degree of uncertainty to which mere smoothing of past variations may be restricted.
Legislation, regulation and social pressures from organized groups are different today from their past arraignment. They continue to change as well. We are asked to discontinue things to which we are accustomed, new challenges arise from technology and new opportunities as well. Investments with long gestation are par for many courses, yet the futility of past data grows as we travel ever more distant in to the future. However, risk management methods allow for both existential learning and for structured protection from hypothetically conceived risks. We can make decisive moves now to protect assets from future events. This infers that the value of the same asset can be different depending on the assumptions we make today about tomorrow. This is a real situation at ground zero for a business person in a line function, though it can be a nightmare without utility for the econometrist! We need a bridge between the theoretical elegance of mathematical finance and the practical realities of risk management in the business world.
Independent variables, in changing combinations, have varying time lags before they take perceptible effect on statutory financial statements. Quantile regression methods can account for such variability when used by people internal to an organization and privy to secure data. However, the most important valuation operations have to take place with only information in the public domain, some of which may not be in numerical form. This is another crucial limitation to the use of historical numbers for predicting future cash flows from an investment today.
The Risk Management Triad
There are three major lines of management action that affect the risks of business and hence the probability of realization of revenues projected for the future from investments. Each of these