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.
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