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CHAPTER 8: RISK RETENTION/REDUCTION DECISIONS (FACTORS AFFECTING COST…
CHAPTER 8: RISK RETENTION/REDUCTION DECISIONS
RISK RETENTION (Part 1) :star: Decision to accept the uncertainty associated with particular risk exposure.
RISK REDUCTION :star: Decision to reduce uncertainty.
FACTORS AFFECTING COST INCREASED RETENTION
Product characteristics :red_cross:
Correlation of losses with other cash flows :red_cross:
Financial leverage :red_cross:
Investment opportunities :red_cross:
Correlation of losses with investment opportunities :red_cross:
Correlation of losses :red_cross:
:check: Reduce exposure to insurance
market volatility.
:check: Reduce moral hazard.
:check: Avoiding implicit taxes due to
insurance price regulation.
:check: Maintain use of funds.
:check: Avoid high premiums caused by
asymmetric information.
BENEFITS
Disaggregated VS Aggregated Approach
Unnecessary coverage argument :recycle:
Complexity problem :recycle:
Transaction Cost :recycle:
Moral hazard problem :recycle:
COMPARISON OF DERIVATIVES & INSURANCE
:check: Basis risk and extent of risk reduction
:check: Liquidity
:check: Market price Vs. Specific losses
:check:Contracting cost
HEDGING WITH DERIVATE CONTRACTS (PART 2)
:star: Contract with payoff derived from the value of some other asset or index.
:star: The asset on which the derivative contract is based called as "UNDERLYING ASSET"
:star: Examples types of risk that are hedged:-
--> Commodity prices
--> Interest rates
--> Exchange rates
OPTIONS
A contract between 2 parties in which buyer has a right but not the obligation to buy or sell a specified asset at a specified at or before specified date from seller.
Transaction between 2 parties simultaneously exchange cash flow. The rate at which the amounts are exchange is predetermined based on either a fixed amount/amount to be based on a reference measure.
Swap contracts are a series of forward contracts.
FORWARD/FUTURE CONTRACTS
A contract between 2 parties to buy/sell an asset in future date but a price is determine today.
Equal to the difference between the actual price of the underlying asset and some pre-determined price.
It is called "Forward Price/Future Price".
SWAP CONTRACTS