Final answer:
The organization's total cost of risk associated with an asset or activity is calculated considering the expected rate of return, risk, and actual rate of return. The expected rate of return is the average return over time, while risk measures the uncertainty of profitability. Evaluating potential payoffs and considering variations in actual returns helps determine the total cost of risk.
Step-by-step explanation:
The organization's total cost of risk associated with an asset or activity is calculated by considering the expected rate of return, risk, and the actual rate of return. The expected rate of return is the average return that an investment or project is expected to provide over a period of time. Risk measures the uncertainty of the project's profitability, including factors such as default risk and interest rate risk.
To calculate the total cost of risk, an organization needs to evaluate the potential payoffs and returns of the asset or activity. A high-risk investment can have a wide range of potential payoffs, while a low-risk investment may have returns that are fairly close to the expected rate of return consistently. The actual rate of return takes into account the total return including capital gains and interest paid on the investment.
For example, let's say an organization invests in a project with an expected rate of return of 10%. However, the project carries a high level of risk due to market volatility and other factors. In some months or years, the actual rate of return may be significantly higher than 10%, while in other months or years, it may be lower. The organization needs to factor in these variations and uncertainties to calculate the overall total cost of risk associated with the asset or activity.