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.