International Risk Management
International Risk Management FINA 4355
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This 2 page Class Notes was uploaded by Miss Quentin Grady on Saturday September 19, 2015. The Class Notes belongs to FINA 4355 at University of Houston taught by Dan Jones in Fall. Since its upload, it has received 60 views. For similar materials see /class/208188/fina-4355-university-of-houston in Finance at University of Houston.
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Date Created: 09/19/15
Comparison of Derivatives and Insurance Contracts An insurance contract can be Viewed as a derivative contract where the underlying asset is the value of losses experienced by the insured There are both similarities and important differences DERIVATIVES Market Value Used to hedge risk arising from unexpected changes in market prices Options and futures of interest to hundreds of companies that use commodities INURANCE Speci c Losses Hedge risk arising from losses speci c to the insured An insurance contract derived from liability or property would be speci c to only one rm Basis risk and extent or risk reduction basis risk is the uncertainty about effectiveness of a hedge More Basis Risk A rm may experience a drop in pro ts as derivatives may have lower payoff Contracting Costs Less because of moral hazard and adverse selection Individuals cannot in uence the payoff Outside in uence of individual rms results in less costs for investigation and monitoring Capital Costs Bring together user and producer and reduces price risk for both Do not have to physically trade the commodity Lower since the matching parities with negatively correlated exposures Less Basis Risk Little uncertainty about quality of hedge ignoring insolvency Higher Loss payoffs in uenced by the actions of the insured party Moral hazard more severe Firms have more information about expected losses creating adverse selection Must incur cost to investigate and monitor Losses experienced by one rm do not trigger a simultaneous gain by another Losses tend to be independent or perhaps positively correlated across rms From insurance company standpoint risks reduced thru diversi cation Sell to many different policyholders creating higher marketing and underwriting costs Capital A small amount of capital needed To ensure contractual performance Derivatives will require a payment Only when firms cash ow otherwise Would be high Liquidity Greater Large numbers affected by prices Lower transaction costs Firm can quickly establish a hedge Liquid market Buy or sell quickly Insurers have to hold capital to pay claims and this cost is an additional cost Must also hold capital to satisfy policyholders Less Modification to provide more of less coverage can take time and create expenses Illiquid market Must wait for someone to pay asking Price or lower price
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