An Econometric Adjustment for Risk
May 8, 2010 in Transfer Pricing Report
The risk-return trade-off refers to an expectation of a positive relationship between increasing risk and increasing reward. This relationship is firmly ensconced within both the U.S. Section 482 regulations and the Organization for Economic Cooperation and Development transfer pricing guidelines for multinational enterprises, though only the OECD guidelines state so explicitly, in paragraph 1.23: “[I]n the open market, the assumption of increased risk will also be compensated by an increase in the expected return.”
Such a positive relationship has been observed empirically over time based on returns among various asset classes stratified by risk. When the return on different asset classes is measured as the mean of annual returns over a long period, and the risk as the variance of annual returns, a constant positive relationship has been observed between the change in the mean of annual returns from one asset class to another and the standard deviation of the annual returns. This has implications for the identification and pricing of risk in a transfer pricing context.
This concept is perhaps most important in the context of business restructurings and the determination of the remuneration for limited-risk entities. Recent comments by the OECD emphasize this point:
Business restructurings typically involve a trade-off between possibly higher-but-more-volatile profits or losses (e.g., for a full-fledged manufacturing activity) and lower-but-more-stable profits (e.g., for a contract manufacturing activity).
In this view, risk is clearly associated with a higher volatility of profits, and “stability” of profits is synonymous with lower volatility. This is an interesting concept, because among unrelated parties there is no market segment that can be described as comprising competitors operating in a “limited risk” environment with guaranteed stable returns. It is not obvious what type of risk adjustments should be made to convert a set of full risk-bearing comparables into a set reflecting a highly customized and often much reduced set of risks. However, the need for such an adjustment has been recognized by practitioners, as elucidated in an earlier article: Enjoying this article? To continue reading you need to take out a FREE trial to the Transfer Pricing Library.
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