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Chapter 8 (RISK RETENTION/REDUCTION (BENEFIT (Save premium loading and…
Chapter 8
RISK RETENTION/REDUCTION
BENEFIT
Save premium loading and transaction costs
reduce exposure to insurance market volatility
reduce moral hazard
reduce implicit tax due
maintain used of fund
avoid high premiums
DEFINITION
risk reduction
reduce uncertainty
risk retention
accept uncertainty
FACTOR AFFECTING
Ownership Structure
Firm size
Correlation of losses
CF
Investment Opportunities
investment Opportunities
Product Characteristics
Financial Leverage
EVIDENCE
On insurance company
Used of derivatives
Gold Mining
Oil and gas
APPROACHES
aggregated
low transaction cost
low unnecessary coverage
dis-aggregated
high unnecessary coverage
high transaction cost
DERIVATIVES VS INSURANCE
Market Price vs specific lost
Basic Risk vs Extend of risk Extension
Liquidity
Contracting Cost
EXAMPLE OF CONTRACT
Options
characteristic
contract between 2 parties
1 buyer has right but no obligation to buy or sell assets before specified date to other party
Put Option
receive +ve payoff only if value of assets less than exercise price
Basis Risk
Uncertainty in relationship between variables hedged and derivatives contract payoff.
Forward Contract
contract between 2 parties to buy/sell assets in future date but price determine today
Called forward price/future price
Swap Contract
transaction of 2 parties
involves in CF
rate of exchange is predetermine
fixed amount
reference measure
DERIVATIVES CONTRACT
contract that derives from some values of other assets