Just as there is Direct and Indirect lending to deal with lending problems, there are the Futures market and Forward intermediaries, respectively, to deal with problems of forward transactions.
Futures market - Its the analog of the stock exchange. Suppose that I am selling copper to a client company as a forward transaction. Instead what I could do is go to the futures market and sell copper futures to traders there. Each contract commits you to deliver certain amount of copper at a certain time at a decided price. The price would be determined by supply and demand. The distinct advantages are -
1) Both parties are guaranteed against default. If I am not able to deliver copper, the exchange will provide the buyer with copper at the previously agreed price. If the buyer fails to keep his part of the promise, the exchange will buy from me at the agreed price.
2) Its a place to find a huge pool of buyers and traders. The contracts are standardized to increase the no of potential traders ( standard amount of standard grade to be delivered at standard time ). Thus you get a fair price and transaction costs are low.
3) Liquidity problem is solved. Suppose that you know beforehand that you are not going to be able to supply the promised copper. All you do is ask the exchange to buy you the same no. of copper futures as the ones you have sold. Since you will now be obliged to deliver and accept tht much copper at the stipulated time, it gets nullified.
Note that futures trading exists for metals, agricultural commodities, oil, etc.
Forward Intermediaries - Forward intermediaries act as intermediates between two parties involved in frwd transaction. Suppose party A ( Japanese ) owes party B ( Indian ) 100000 Rs after buying 100000 Rs worth of exports from B. A sells off these exports in Japan, expecting to make a certain profit after paying off B after, say, one year. However, A notices that the Yen has fallen w.r.t. the Rupee such that 100000 Rs in now worth much more Yen. Thus, A is now facing a loss because of exchange rate variation. Here, a bank, which buys and sells exchange rate forward can help A. A will buy 100000 Rs forward ( to be given to it after 4 months ) at the current exchange rate and will pay off B with these, thus being in profit as per its calculations. Its is like locking a price. Doesn;t this pass on the risk to the bank?? Answer is NO. Because the Bank has people interested in selling Yen forward as well (those who expect Yen to rise against Rupee). These two cases offset the bank's risk. Main advantage here is lowering of transaction costs and surety factor of the bank. The bank is able to offer liquidity because of pooling. Also, it is well equipped to assess all credit standings and choose customers wisely.
Wednesday, April 22, 2009
Solutions ( Risk ) - Dealing with insurance problems
Insurance Policy
When an individual, say a farmer, is insured by an insurance company, the farmer basically pays a premium ( pre-decided amount to be paid periodically) to the company , in return for which, the company agrees to compensate him for a chance damage like a godown burn. The company deals with this by insuring , say, 200000 farmers threby ensuring that even if 200 farmers ask for claims the insured ask for claims, the total amount of premium money collected is more and the company is in profit. Plus, the company usually also invests the premium money into profitable ventures, thereby increasing the profit.
The distinct advantages for the farmer over reciprocal insurance are that the uncertainty of timing in reciprocal insurance is eliminted as the premiums are to be paid at known times and are usually a small fraction of the total claim money. Plus, there is the backing of the capital of the insurance company.
Types of Insurance Risks - Actuarial and Non-actuarial
Insurance policies would generally cover risks of known probability or estimable probability. These are called Actuarial risks. These include property-liability insurance ( homes, cars, automobiles ) and life insurance ( illness, death ).
However, there are Non-actuarial risks, whose probability calculation is totally a shot in the dark, eg : whether a satellite launch would fail or not. In such cases, the financial system offers external insurance. A number of Insurers, themselves not exposed to the risk agree to bear part of the claim for a premium. If there is a loss, they pay their share and if not, they are ahead by the premium amount. This is somewhat like gambling.
Dealing with incentive problems
Problems of moral hazard and adverse selecion are more serious for insurance companies than in the case of reciprocal insurance. To solve the problem of moral hazard ( slack behavious of an insured person ) , the insurance policy is such that a small agreed fraction of the loss is to be paid by the insured person himself. This puts him under the compulsion of being careful. The company can also make care a compulsive condition of the coverage policy ( eg: a farmer cannot store combustible material in his godown ).
Problem of adverse selection (high-risk is pro-insurance and low-risk is against it ) might lead to the claims beiung too many in number and the insurance company will go into a huge loss. The only way to solve this problem is a careful assessment of the risks that an insurance company covers to distinguish risks properly and also to tailor its premiums to reflect the risk so that the premiums for low-risk persons are less than those for high-risk persons.
When an individual, say a farmer, is insured by an insurance company, the farmer basically pays a premium ( pre-decided amount to be paid periodically) to the company , in return for which, the company agrees to compensate him for a chance damage like a godown burn. The company deals with this by insuring , say, 200000 farmers threby ensuring that even if 200 farmers ask for claims the insured ask for claims, the total amount of premium money collected is more and the company is in profit. Plus, the company usually also invests the premium money into profitable ventures, thereby increasing the profit.
The distinct advantages for the farmer over reciprocal insurance are that the uncertainty of timing in reciprocal insurance is eliminted as the premiums are to be paid at known times and are usually a small fraction of the total claim money. Plus, there is the backing of the capital of the insurance company.
Types of Insurance Risks - Actuarial and Non-actuarial
Insurance policies would generally cover risks of known probability or estimable probability. These are called Actuarial risks. These include property-liability insurance ( homes, cars, automobiles ) and life insurance ( illness, death ).
However, there are Non-actuarial risks, whose probability calculation is totally a shot in the dark, eg : whether a satellite launch would fail or not. In such cases, the financial system offers external insurance. A number of Insurers, themselves not exposed to the risk agree to bear part of the claim for a premium. If there is a loss, they pay their share and if not, they are ahead by the premium amount. This is somewhat like gambling.
Dealing with incentive problems
Problems of moral hazard and adverse selecion are more serious for insurance companies than in the case of reciprocal insurance. To solve the problem of moral hazard ( slack behavious of an insured person ) , the insurance policy is such that a small agreed fraction of the loss is to be paid by the insured person himself. This puts him under the compulsion of being careful. The company can also make care a compulsive condition of the coverage policy ( eg: a farmer cannot store combustible material in his godown ).
Problem of adverse selection (high-risk is pro-insurance and low-risk is against it ) might lead to the claims beiung too many in number and the insurance company will go into a huge loss. The only way to solve this problem is a careful assessment of the risks that an insurance company covers to distinguish risks properly and also to tailor its premiums to reflect the risk so that the premiums for low-risk persons are less than those for high-risk persons.
Sunday, December 28, 2008
Which one's better? Direct or Indirect Lending ?
Although both are equally poised, it will depend greatly on the situation. Also, it depends whether you are a borrower or a lender. Suppose that I want to borrow a sum of Rs. 1 crore for my company. Since 1 crore is not that huge a sum, I would like to incur as less expenditure as possible in information gathering and would also like to avoid the costs involved in a public issue. Thus, I would go to a reputed bank and get my small or short-term loan, since borrowing would then become cheaper. Also, many borrowers do not have a reputation of being creditworthy and hence might not have an option but to go to a bank.
However, if a borrower has past reputation and wants to raise large sums of money, he might find the direct market as an easier path. Infact, it may not even be possible to borrow very large sums indirectly that is, from banks. Capacity of a direct market is much higher.
Again, when it comes to lenders, I have a less risk and more liquidity when I involve a bank. However, along with the lower chance of loss comes a lower chance of gain. You may get rich with a clever investment in stocks ( direct secondary market ) but you won't get rich by putting your money in a bank.
Again, banks have a specialization edge and hence, in case of trouble, can handle the situation better. They can actually tell when the problem faced by a borrower is temporary and when it is permanent and can make a wise decision. In a direct market, the people might not know much about the company's standing and might take a wrong decision, like forcing a company into bankruptcy over unnecessary fears, when the best thing could be to let the company run for some more time.
However, if a borrower has past reputation and wants to raise large sums of money, he might find the direct market as an easier path. Infact, it may not even be possible to borrow very large sums indirectly that is, from banks. Capacity of a direct market is much higher.
Again, when it comes to lenders, I have a less risk and more liquidity when I involve a bank. However, along with the lower chance of loss comes a lower chance of gain. You may get rich with a clever investment in stocks ( direct secondary market ) but you won't get rich by putting your money in a bank.
Again, banks have a specialization edge and hence, in case of trouble, can handle the situation better. They can actually tell when the problem faced by a borrower is temporary and when it is permanent and can make a wise decision. In a direct market, the people might not know much about the company's standing and might take a wrong decision, like forcing a company into bankruptcy over unnecessary fears, when the best thing could be to let the company run for some more time.
Solutions ( Borrowing and Lending ) - Indirect Lending and Bankruptcy
This part has helped me a great deal to understand why Lehman Brothers actually went bankrupt. Let us see why. Indirect Lending is a process wherein I shall lend my money to a company which needs it, but through a financial intermediary. Lehman was one such intermediary. Suppose I lend my 5 lac Rs to Lehman and Lehman loans it to this company. Although I am the ultimate source of the loan, now the promise to me is from Lehman and not from the company. If the company defaults, the bank's promise to me is not affected. Since Lehman is a renowned bank, I am hardly at a risk of Lehman defaulting as opposed tot he company defaulting. (That sounds funny considering what happened, but that's the precise reason why it shook the world .. The chances of a bank defaulting are one in a million). The following are the distinct advantages -
Informational - Lehman can obtain lots and lots of information being a renowned bank, such information as is not made available to the public at large. The company will also not hesitate to give the info as there is less risk that its secrets will be leaked. So the bank is better poised to invest your money in a good way.
Pooling - Compared to individual investors banks make very large loans. This is because making large loans is relatively less expensive than making small ones because the other costs like those of gathering information are the same. So why not make a larger loan to get a larger profit than make a small loan ? This has a big advantage as far as the liquidity problem is concerned. I can get my money back from Lehman much easier than I can get it back from the company. Lehman is expected to have lots of money with it at any given time, considering that so many lenders lend money to it everyday. Although withdrawals and deposits are both pretty high, but their timing is different by nature - only rarely will a day of many withdrawals be a day of very few deposits. So in general, the bank will always have ready cash to give to any depositor who needs it there and then. However, if all depositors want to withdraw their money at once ( exactly what heppened with Lehman ), then the bank will be in trouble. Such a tendency of the depositors is called a bank run.
Gains from specialization - I don't think this part needs any explanation. Banks are obviously better at assessing the creditworthiness of borrowers as also in reading financial statements etc.
Value of a Continuing Relationship - A company will expect to come back to a bank for borrowing more in the future and hence, it would not like to jeopardize its ability to do so by failing to pay up on time.
Diversification - The amount of money that I, as an individual, can lend to the company is small compared to the average amount that borrowers like the above company want to borrow. I will obviously not be able to lend to more than a few companies. If they default, I am gone !! However, Lehman has deposits of thousands of people like me. It can therefore make many small loans to many companies out of the money which I give it. Even if a few default, I am not at much risk. this is called diversification. As such, if I was sure that my company is good, then I would definitely get a higher return if I directly lent the money without Lehman being there. But then I can never be sure of such a thing. There is a chance factor involved there. If my company defaults, I don't get anything. In case Lehman invests, the chance factor is such that even after considering all probability of the companies defaulting, I am sure to get a sure return of 5 % from Lehman on my money. Its just a matter of deciding which one's better? A sure return of 5 % ? Or a possible return of 10 % ?
What is Bankruptcy after all ? Bankruptcy if filed when an organization is unable to pay off its debts. Either the organization files it, or the creditors may be able to force the organization into it. It is thus, a legal process, supervised by a court, that settles all claims against the bankrupt, tot he extent possible. The concept is to ensure that debts are paid off in an orderly manner rather than everyone scrambling to get theirs first. There are two types of bankruptcy - liquidation and re-organization. In a liquidation, the organization ceases to exist and its remaining assets are sold to pay off the creditors to whatever extent possible. In a reorganization, all creditors and the organization agree upon a plan for future payment of all or a part of corporation's debts. However, bankruptcy is costly in terms of legal fees and the firm's reputation. sometimes, it may be in the interest of lenders to let the organization continue and repay later, especially if the problem is temporary.
Informational - Lehman can obtain lots and lots of information being a renowned bank, such information as is not made available to the public at large. The company will also not hesitate to give the info as there is less risk that its secrets will be leaked. So the bank is better poised to invest your money in a good way.
Pooling - Compared to individual investors banks make very large loans. This is because making large loans is relatively less expensive than making small ones because the other costs like those of gathering information are the same. So why not make a larger loan to get a larger profit than make a small loan ? This has a big advantage as far as the liquidity problem is concerned. I can get my money back from Lehman much easier than I can get it back from the company. Lehman is expected to have lots of money with it at any given time, considering that so many lenders lend money to it everyday. Although withdrawals and deposits are both pretty high, but their timing is different by nature - only rarely will a day of many withdrawals be a day of very few deposits. So in general, the bank will always have ready cash to give to any depositor who needs it there and then. However, if all depositors want to withdraw their money at once ( exactly what heppened with Lehman ), then the bank will be in trouble. Such a tendency of the depositors is called a bank run.
Gains from specialization - I don't think this part needs any explanation. Banks are obviously better at assessing the creditworthiness of borrowers as also in reading financial statements etc.
Value of a Continuing Relationship - A company will expect to come back to a bank for borrowing more in the future and hence, it would not like to jeopardize its ability to do so by failing to pay up on time.
Diversification - The amount of money that I, as an individual, can lend to the company is small compared to the average amount that borrowers like the above company want to borrow. I will obviously not be able to lend to more than a few companies. If they default, I am gone !! However, Lehman has deposits of thousands of people like me. It can therefore make many small loans to many companies out of the money which I give it. Even if a few default, I am not at much risk. this is called diversification. As such, if I was sure that my company is good, then I would definitely get a higher return if I directly lent the money without Lehman being there. But then I can never be sure of such a thing. There is a chance factor involved there. If my company defaults, I don't get anything. In case Lehman invests, the chance factor is such that even after considering all probability of the companies defaulting, I am sure to get a sure return of 5 % from Lehman on my money. Its just a matter of deciding which one's better? A sure return of 5 % ? Or a possible return of 10 % ?
What is Bankruptcy after all ? Bankruptcy if filed when an organization is unable to pay off its debts. Either the organization files it, or the creditors may be able to force the organization into it. It is thus, a legal process, supervised by a court, that settles all claims against the bankrupt, tot he extent possible. The concept is to ensure that debts are paid off in an orderly manner rather than everyone scrambling to get theirs first. There are two types of bankruptcy - liquidation and re-organization. In a liquidation, the organization ceases to exist and its remaining assets are sold to pay off the creditors to whatever extent possible. In a reorganization, all creditors and the organization agree upon a plan for future payment of all or a part of corporation's debts. However, bankruptcy is costly in terms of legal fees and the firm's reputation. sometimes, it may be in the interest of lenders to let the organization continue and repay later, especially if the problem is temporary.
Solutions ( Borrowing and Lending ) - Direct Lending
Now, I am a lender who wishes to lend Rs. 5 lac to a company that in total needs Rs. 1 crore. I intend to do so to get a mutual benefit out of this lending.
To solve the problem of need for information, there are various market institutions that make it easier to lend. The financial press - Economic Times, Business Week, etc. Also, accounting firm's audit a firm's books. Firms that borrow from the public have to make such information public. There are also many investment information services which function like KPO's and provide information.
To solve the problem of writing a contract, new securities such as the Rs. 1 crore worth of securities that the above company has to offer are usually sold to the public through an underwriter, generally a securities firm. The company is the that needs the money is the issuer. of the securities. The underwriter will negotiate the terms of the loan contract and will also appoint a trustee to ensure compliance of the rules. This trustee is usually a bank. The underwriter usually buys the whole securities from the issuer and then sells it to the public.
Everybody here will be having an interest in doing their work well, because it affects the business that they are going to get in the future. For instance, if the underwriter ( securities firm ) gets a reputation of selling securities that turn out to be duds, then it is doomed. This means that the costs to me are greatly reduced as I hardly have anything to do on my own and the info available in more reliable.
Now, to address the problem of liquidity conflict. Suppose that circumstances change immediately after I lend my money and I need my money back. Obviously the company is under no obligation to give it back to me so soon. Financial markets have a solution to this - a way for me to get my money back without the company having to give it to me. I could simply sell my security to someone else, that is, transfer the 5 lacs from my name to somebody else's and get paid that much amount by that guy. These securities are transferable securities. Of course, there again would be the problem of having to find a buyer, which would again make me face the problems of information, reliability, blah blah. However, there is an organised market for such a trade to take place and it is called a secondary market. A market for new issues is called a primary market. There are two important types of people that come into picture in a secondary market - Dealers and Brokers. Dealers stand ready to buy at quoted prices. I could sell my securities immediately by contacting the dealer and accepting his price. Brokers will bring buyers and sellers together and themselves would not be involved in buying or selling. Dealers earn through the difference between the price at which they sell it to some other buyer and price at which they buy from you whereas broker will charge a commission for their services. In such a dealer-broker system, if organization is loose and communication is mainly over telephone or internet, it is called an OTC ( Over-The -Counter ) market. However, if organization is more structured and communication is face-to-face, it is called an exchange, like the Bombay Stock Exchange.
Clearly, if secondary market is good, loan will be more attractive to lenders and thus, borrowers will have to pay less returns. This is how both the borrowers and lenders will benefit.
To solve the problem of need for information, there are various market institutions that make it easier to lend. The financial press - Economic Times, Business Week, etc. Also, accounting firm's audit a firm's books. Firms that borrow from the public have to make such information public. There are also many investment information services which function like KPO's and provide information.
To solve the problem of writing a contract, new securities such as the Rs. 1 crore worth of securities that the above company has to offer are usually sold to the public through an underwriter, generally a securities firm. The company is the that needs the money is the issuer. of the securities. The underwriter will negotiate the terms of the loan contract and will also appoint a trustee to ensure compliance of the rules. This trustee is usually a bank. The underwriter usually buys the whole securities from the issuer and then sells it to the public.
Everybody here will be having an interest in doing their work well, because it affects the business that they are going to get in the future. For instance, if the underwriter ( securities firm ) gets a reputation of selling securities that turn out to be duds, then it is doomed. This means that the costs to me are greatly reduced as I hardly have anything to do on my own and the info available in more reliable.
Now, to address the problem of liquidity conflict. Suppose that circumstances change immediately after I lend my money and I need my money back. Obviously the company is under no obligation to give it back to me so soon. Financial markets have a solution to this - a way for me to get my money back without the company having to give it to me. I could simply sell my security to someone else, that is, transfer the 5 lacs from my name to somebody else's and get paid that much amount by that guy. These securities are transferable securities. Of course, there again would be the problem of having to find a buyer, which would again make me face the problems of information, reliability, blah blah. However, there is an organised market for such a trade to take place and it is called a secondary market. A market for new issues is called a primary market. There are two important types of people that come into picture in a secondary market - Dealers and Brokers. Dealers stand ready to buy at quoted prices. I could sell my securities immediately by contacting the dealer and accepting his price. Brokers will bring buyers and sellers together and themselves would not be involved in buying or selling. Dealers earn through the difference between the price at which they sell it to some other buyer and price at which they buy from you whereas broker will charge a commission for their services. In such a dealer-broker system, if organization is loose and communication is mainly over telephone or internet, it is called an OTC ( Over-The -Counter ) market. However, if organization is more structured and communication is face-to-face, it is called an exchange, like the Bombay Stock Exchange.
Clearly, if secondary market is good, loan will be more attractive to lenders and thus, borrowers will have to pay less returns. This is how both the borrowers and lenders will benefit.
Basics of Finance - Trade in Risk and related problems
"Risk" is a very important part of finance. As is very evident from the recent economic disaster, every dealing in finance comes with an attached risk. Two aspects that protect us from risks are - Insurance and Forward Transactions.
Insurance - Insurance protects a person from financial losses involved in accidents, illnesses or other disasters. There are two types of Insurance - Reciprocal and External. Reciprocal insurance is one in which a group of people, all of whom are exposed to a similar kind of risk, agree to share the losses incurred to any one of them because of an unexpected disaster. For instance, if a farmer's godown burns down, other farmers will contribute amounts to help rebuild it. It is a form of trade because in return for the relatively small amount of money that a farmer has to contribute for his fellow's loss, he gets a large amount of help in case his godown burns down. On the other hand, External Insurance is one in which an arrangement is made with people who are not themselves at risk, to help the insured person during his bad times, in return for a periodic payment that this insured person will keep making to these "external" people.
Problems with Insurance - Insurance is cheaper and more effective if the risk can be broken up among a larger no. of people with greater total resources. However, this brings in the cost of information - gathering contracting and monitoring. Next is the problem of moral hazard - tendency of an insured person to take a greater risk, simply because he knows that he is insured. For instance, I might not care about my car getting hit and undergoing a little damage if I know that it is insured ( provided I know that I am safe ) Third is the problem of adverse selection - tendency of worse risks to buy insurance and better risks not to. For instance, an owner of a car which is already in poor shape would find insurance more attractive.
Forward Transactions - A forward transaction is a means to protect a trader from unexpected market price fluctuations. For instance, Suppose that I own a copper mine and am ready to sell a lac tonnes of copper to my client by mid next year. My total cost price per ton of copper is Rs. 4000 . I am expecting to sell this copper at a Selling Price of Rs. 6000, which a client has promised me. However, by the time I actually sell this to my client to keep my promise, I find that the market price of copper is now Rs. 3500. So I have to seel at a loss. Such a risk is called a price risk. Such a risk is mitigated by a forward transaction, wherein, a price is set today for delivery and payment in the future, that is, mid next year. I and my client agree that I shall seel the copper to him at Rs. 6000 per ton in mid next year. There are two types of buyers you will find for yourself. One would be someone who is worried about a price rise of copper and wants to protect itself from it. By buying forward the required copper from me, such a client can protect itself. It is thus a hedger - someone who takes a position in one asset to offset the risk of a position in another asset. Another type of client I may find is a speculator. This is a person who does not want my copper but is buying it from me in the hope of profiting from it ( Suppose he expects the price to rise to Rs. 9000 per ton by mid next year)
Problems in Forward Transaction - The danger , again, is default. A forward transaction involves two promises - My promise that I will sell it by mid next year and my client's promise that they shall buy it. Suppose my client goes bankrupt and cannot accept my delivery, then I have to find another client fast and sell at some price which may be less than what my earlier client had promised me. Again, if I default in my delivery, then my client will have to find another copper seller and buy copper at some price which may be more than what I promised to give them. This risk is called a replacement risk. Again, there is also , as usual, the cost of information - gathering contracting and monitoring.
Insurance - Insurance protects a person from financial losses involved in accidents, illnesses or other disasters. There are two types of Insurance - Reciprocal and External. Reciprocal insurance is one in which a group of people, all of whom are exposed to a similar kind of risk, agree to share the losses incurred to any one of them because of an unexpected disaster. For instance, if a farmer's godown burns down, other farmers will contribute amounts to help rebuild it. It is a form of trade because in return for the relatively small amount of money that a farmer has to contribute for his fellow's loss, he gets a large amount of help in case his godown burns down. On the other hand, External Insurance is one in which an arrangement is made with people who are not themselves at risk, to help the insured person during his bad times, in return for a periodic payment that this insured person will keep making to these "external" people.
Problems with Insurance - Insurance is cheaper and more effective if the risk can be broken up among a larger no. of people with greater total resources. However, this brings in the cost of information - gathering contracting and monitoring. Next is the problem of moral hazard - tendency of an insured person to take a greater risk, simply because he knows that he is insured. For instance, I might not care about my car getting hit and undergoing a little damage if I know that it is insured ( provided I know that I am safe ) Third is the problem of adverse selection - tendency of worse risks to buy insurance and better risks not to. For instance, an owner of a car which is already in poor shape would find insurance more attractive.
Forward Transactions - A forward transaction is a means to protect a trader from unexpected market price fluctuations. For instance, Suppose that I own a copper mine and am ready to sell a lac tonnes of copper to my client by mid next year. My total cost price per ton of copper is Rs. 4000 . I am expecting to sell this copper at a Selling Price of Rs. 6000, which a client has promised me. However, by the time I actually sell this to my client to keep my promise, I find that the market price of copper is now Rs. 3500. So I have to seel at a loss. Such a risk is called a price risk. Such a risk is mitigated by a forward transaction, wherein, a price is set today for delivery and payment in the future, that is, mid next year. I and my client agree that I shall seel the copper to him at Rs. 6000 per ton in mid next year. There are two types of buyers you will find for yourself. One would be someone who is worried about a price rise of copper and wants to protect itself from it. By buying forward the required copper from me, such a client can protect itself. It is thus a hedger - someone who takes a position in one asset to offset the risk of a position in another asset. Another type of client I may find is a speculator. This is a person who does not want my copper but is buying it from me in the hope of profiting from it ( Suppose he expects the price to rise to Rs. 9000 per ton by mid next year)
Problems in Forward Transaction - The danger , again, is default. A forward transaction involves two promises - My promise that I will sell it by mid next year and my client's promise that they shall buy it. Suppose my client goes bankrupt and cannot accept my delivery, then I have to find another client fast and sell at some price which may be less than what my earlier client had promised me. Again, if I default in my delivery, then my client will have to find another copper seller and buy copper at some price which may be more than what I promised to give them. This risk is called a replacement risk. Again, there is also , as usual, the cost of information - gathering contracting and monitoring.
Friday, December 26, 2008
Basics of Finance - Trade in Borrowing and Lending and related problems
At the very beginning of it, there are three facets of Trade that need to be studied - Saving, Investment and Lending. While we all know and have experienced the nitty-gritties of Savings, right from saving pocket money for weeks together to buy a gift for somebody or saving up on leisure time for a couple days to watch the Indo-Pak cricket match, Investment is a tad bit more complicated.
Why is investment needed in the first place ? Let us suppose that I am planning to start a shoe factory. However productive my idea is, I first need to lay my hands on some cash before I start making profit. This cash is called Capital and is an investment. Capital is of two types - Working Capital and Fixed Capital. I need to buy some land and set up my factory as well as buy the required machinery. This long term investment is called fixed capital and is done at the very beginning. Again, I need to pay my workers daily wages, buy raw material every week or month and also need to support a supply chain to sell my goods. These expenses, which vary according to demand and are like everyday expenses and are called Working Capital. The above was an example of Business Investment.There are, other forms of investment too, termed as Household investment. For instance, the fees I pay for my college are also an investment, the returns on which would start showing after I start earning my salary. Similarly, buying a car is also an investment, although not one that would give future returns. It would rather give me a service over a continuous period of time.
The two aspects that directly result from the above are Borrowing and Lending. Both Borrowers and Lenders gain from trade. A borrower like me would be able to start my factory and start earning good profit while a lender earn an interest on the money that he lends me. His other options would have been to either save up that money for years together or invest the money in some other form, but finding such a productive investment is a mammoth task in itself. So he gains from this trade too.
However, as with any system, there are basic problems involved with borrowing and lending. While buying goods from a shop by paying cash or bartering some other goods, called Cash trading ( exchange of value for value ) is fair and simple, Credit Trading ( involving exchange of value for a promise) is not as simple. My lender gives up some of his purchasing power to me and I give him a promise that I will return his money after a specific period of time. The problem is that I may not keep the promise because I can't predict the situation a few years down the line. That is, I may default. To have a detailed look at the problem and the costs involved, let us take the following example:
Suppose that I am a lender with huge amounts of cash. A company has approached me for a loan. The first thing that I, as an intelligent lender, would want to do is to gauge the risk in lending my money. So I would like to analyze the company's way of working, how well it is doing, how well it is predicted to do in the near future, etc. Since the company would always want to show itself in a positive light, I have to check the reliability of the information that I study. This is the first cost involved - The cost of acquiring and processing information.
Now, provided I decide to go ahead with the loan. I need to enter into a contract with the owner of the company to make sure that the whole process is overseen by law. Negotiating and drawing up the contract requires both time and fees ( legal, etc.). So the second cost is - The cost of negotiating and writing a contract.
Next, the type of contract I sign is also of paramount importance. ** There are two types of contracts in lending - Debt contract and Equity contract. ** An equity contract is one wherein if I lend an amount of say 10 lac to the company, I shall have a stake in the company's profits of, say 50%. This means that whatever profits the company makes, I am entitled to get 50% of it. However, the company is not entitled to give me back my 10 lacs. This implies a tax of 50% on the company's profits and hence, the management of the company might not work as hard as you would like them to and the profits could suffer. Also, the owner of the company might get himself a bigger office and make more expenses on perks, because each rupee spent on expenses will only cost him 50 paisa. There have been lots of cases in the global corporate world, where the CEO's of the companies, with themselves having a very low share in the company's profits, have indulged in extravagant expenses because of equity contracts.
On the other hand, a debt contract entitles the company to pay me a certain amount, say 50 lacs, after a fixed period, say 5 yrs and there is no "tax" on the profits. This will eliminate the problem of the owner not wanting to work hard because every rupee earned beyond 50 lacs is for him to keep. However, this might result in a conflict between myself and the owner of the company. The owner might go with a business strategy that maximizes his profit more than it favors my chances of getting the money back. Thus the third cost is - Incentive problems inherent in lending arrangements.
Fourth problem is that of monitoring the company. I, as a lender, would like to monitor the efforts of the owner in case I have signed an equity contract and also to have veto power on wasteful expenditures. In case of a debt contract, I might like to have a clause which states that until my loan is paid off, the company cannot undertake other loans. These are called loan covenants - which restrict the behavior of the borrower according to the lender's safeguarding of interest. This way, I might be restricting the company from venturing into something profitable. Also, I have to incur the cost of monitoring the compliance of these clauses periodically. Thus, the fourth cost is - The cost of establishing safeguards and monitoring borrower compliance.
Next problem is related to Liquidity. Liquid means capable of being turned into cash quickly without loss. Suppose that I need the money back because of an emergency, immediately after lending it to the company. That is, I would like the loan to be liquid while the company will need the funds to be committed for a long period of time. I might be willing to accept lower liquidity if promised a higher return, but that will be tougher for the owner of the company. Thus the fifth problem is - Conflicting interest over liquidity
The sixth problem is that I am currently feeling dizzy over how much of bhaat I have written in the past one hour. Phew!!! That was more than enough for one blogpost... Ciao
Why is investment needed in the first place ? Let us suppose that I am planning to start a shoe factory. However productive my idea is, I first need to lay my hands on some cash before I start making profit. This cash is called Capital and is an investment. Capital is of two types - Working Capital and Fixed Capital. I need to buy some land and set up my factory as well as buy the required machinery. This long term investment is called fixed capital and is done at the very beginning. Again, I need to pay my workers daily wages, buy raw material every week or month and also need to support a supply chain to sell my goods. These expenses, which vary according to demand and are like everyday expenses and are called Working Capital. The above was an example of Business Investment.There are, other forms of investment too, termed as Household investment. For instance, the fees I pay for my college are also an investment, the returns on which would start showing after I start earning my salary. Similarly, buying a car is also an investment, although not one that would give future returns. It would rather give me a service over a continuous period of time.
The two aspects that directly result from the above are Borrowing and Lending. Both Borrowers and Lenders gain from trade. A borrower like me would be able to start my factory and start earning good profit while a lender earn an interest on the money that he lends me. His other options would have been to either save up that money for years together or invest the money in some other form, but finding such a productive investment is a mammoth task in itself. So he gains from this trade too.
However, as with any system, there are basic problems involved with borrowing and lending. While buying goods from a shop by paying cash or bartering some other goods, called Cash trading ( exchange of value for value ) is fair and simple, Credit Trading ( involving exchange of value for a promise) is not as simple. My lender gives up some of his purchasing power to me and I give him a promise that I will return his money after a specific period of time. The problem is that I may not keep the promise because I can't predict the situation a few years down the line. That is, I may default. To have a detailed look at the problem and the costs involved, let us take the following example:
Suppose that I am a lender with huge amounts of cash. A company has approached me for a loan. The first thing that I, as an intelligent lender, would want to do is to gauge the risk in lending my money. So I would like to analyze the company's way of working, how well it is doing, how well it is predicted to do in the near future, etc. Since the company would always want to show itself in a positive light, I have to check the reliability of the information that I study. This is the first cost involved - The cost of acquiring and processing information.
Now, provided I decide to go ahead with the loan. I need to enter into a contract with the owner of the company to make sure that the whole process is overseen by law. Negotiating and drawing up the contract requires both time and fees ( legal, etc.). So the second cost is - The cost of negotiating and writing a contract.
Next, the type of contract I sign is also of paramount importance. ** There are two types of contracts in lending - Debt contract and Equity contract. ** An equity contract is one wherein if I lend an amount of say 10 lac to the company, I shall have a stake in the company's profits of, say 50%. This means that whatever profits the company makes, I am entitled to get 50% of it. However, the company is not entitled to give me back my 10 lacs. This implies a tax of 50% on the company's profits and hence, the management of the company might not work as hard as you would like them to and the profits could suffer. Also, the owner of the company might get himself a bigger office and make more expenses on perks, because each rupee spent on expenses will only cost him 50 paisa. There have been lots of cases in the global corporate world, where the CEO's of the companies, with themselves having a very low share in the company's profits, have indulged in extravagant expenses because of equity contracts.
On the other hand, a debt contract entitles the company to pay me a certain amount, say 50 lacs, after a fixed period, say 5 yrs and there is no "tax" on the profits. This will eliminate the problem of the owner not wanting to work hard because every rupee earned beyond 50 lacs is for him to keep. However, this might result in a conflict between myself and the owner of the company. The owner might go with a business strategy that maximizes his profit more than it favors my chances of getting the money back. Thus the third cost is - Incentive problems inherent in lending arrangements.
Fourth problem is that of monitoring the company. I, as a lender, would like to monitor the efforts of the owner in case I have signed an equity contract and also to have veto power on wasteful expenditures. In case of a debt contract, I might like to have a clause which states that until my loan is paid off, the company cannot undertake other loans. These are called loan covenants - which restrict the behavior of the borrower according to the lender's safeguarding of interest. This way, I might be restricting the company from venturing into something profitable. Also, I have to incur the cost of monitoring the compliance of these clauses periodically. Thus, the fourth cost is - The cost of establishing safeguards and monitoring borrower compliance.
Next problem is related to Liquidity. Liquid means capable of being turned into cash quickly without loss. Suppose that I need the money back because of an emergency, immediately after lending it to the company. That is, I would like the loan to be liquid while the company will need the funds to be committed for a long period of time. I might be willing to accept lower liquidity if promised a higher return, but that will be tougher for the owner of the company. Thus the fifth problem is - Conflicting interest over liquidity
The sixth problem is that I am currently feeling dizzy over how much of bhaat I have written in the past one hour. Phew!!! That was more than enough for one blogpost... Ciao
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