Differentiating Risk Capacity, Risk Appetite, and Risk Tolerance
The first step toward understanding risk management is to learn the following three important terms:
- Risk capacity: This is the maximum risk an organization can afford to take.
- Risk tolerance: Risk tolerance levels are acceptable deviations from the risk appetite.
- Risk appetite: This is the amount of risk that an organization is willing to take.
The following example further explains these terms.
Mr. A's total savings are $1,000. He wants to invest in equities to earn some income. Since he is risk averse, he decides to invest only up to $700. If the markets are good, he is willing to invest a further $50. In terms of risk capacity, risk appetite, and risk tolerance, the following can be derived:
- Risk capacity: Total amount available, i.e., $1,000
- Risk appetite: Mr. A's willingness to take a risk i.e., $700
- Risk tolerance: Acceptable deviation from the risk appetite...