“Risk aversion does not mean that people and institutions are not willing to take risks. However, they need to be compensated for taking risk” Explain and discuss. There are a number of key issues that need to be discussed on this topic but firstly we will start with the definition of what this statement means. A person or institution is said to be risk averse if they prefer having less risk than more risk, all other things considered being equal. The opposite of this would be a risk seeker (sometimes called risk loving or speculator) and this person/institution actively seeks risk and thus prefers more risk to less risk.
Most financial theories will assume that generally investors are not risk seeking. However, it is possible to observe risk seeking in actual life, those that play the lottery or gamble in casinos accept the expected negative return in return for the thrill of financial risk. There is a point in-between being risk averse and risk seeking, this is known as risk neutrality. This type of investor will neither pay to avoid risk or take it; thus, risk will not affect his decisions. On the whole for this discussion we will be talking about the risk averse investor as this is the vast majority of the lending population.
An investor that is risk averse will require some sort of compensation in order to take a more risky option than they otherwise would. For instance, when considering equities and bonds, anticipated income from equities is less certain than bond income. This is because equity income varies over time and also, in times of crisis, equity claims are below that of bonds in the pecking order. Therefore, investors must be offered additional returns per year to tempt them into buying the higher-risk equities instead of the lower-risk bonds.
This trend will continue with risk and compensation being very strongly correlated. The risk seeker will not follow this trend and will pay to take risks that others would not. The risk neutral investor, as is indicative of his name, will not be affected either way. All of these explanations assume the important rule of ceteris paribus (all other things being equal). An investor that is averse will always have to be compensated for taking risk that they would otherwise not have taken. This can be done either by prevention of the risk even happening in the first place or by cure if the risk does actually unfold.
We will now discuss some of the methods that a lender can use to compensate themselves in these two ways. As previously mentioned the majority of investors need to be suitably compensated for taking risk. This is usually linked with some sort of premium being charged on the investment/lending. A good example of this would be a bank lending to students for instance. From previous experience the bank can attach a probability that one in ten students do not repay their loans. Once a probability has been established the bank can make a rational decision.
If that bank lends to ten students, it will charge a premium so that the nine students they do expect to pay will cover the bank for the loss of money it has made on the student that did not pay up. Thus, to use some numbers, if all ten students want to borrow i?? 100 each from the bank, the bank expects to lose one tenth and thus i?? 100 of all of the loans. Therefore it will charge i?? 100 divided by the 9 expected to pay and come up with a premium of close to i?? 11, thus the nine students will pay the i?? 100 extra lost between them.
A bank can also cover itself for fluctuations in the interest rate by offering loans that have a variable rate of interest and so changes in the interest rate will not mean that the bank is losing money. Therefore, with these examples I have demonstrated how a bank will compensate itself for the risk that it is taking. An investor will be able to attach a probability to risk and thus will be able to calculate a suitable premium. This discussion has demonstrated to us how investors compensate themselves for taking risk through the use of premiums.
When an investor puts money into a business/person it cannot be guaranteed that that business/person will act in the best interest for their money. The key problem is that not all transactors have the same ability to assess the same available information. This potentially creates a moral hazard whereby the transactors with superior information will use it to the disadvantage to the others in the transaction. Another possibility is that agency costs arise due to the borrower aiming his targets in a different direction to the lender.
For instance, a financial advisor that is not paid may well act in his best interests to gain commission unless you pay for his advice. Thus, measures must be taken so that the aims of the principal and agent are both in the same direction. The lender does have ways of reducing the probability that these risks will occur. One of the most favourite ways of doing this is to take some form of security on the loan. This can be security in the form of fixed assets of the borrower such as the borrower’s house, machinery or manufacturing plants etc.
There are other ways that this security can be done, the borrower may have a financial backer for instance that guarantees to pay back monies owed if the issue of default arises. Another sensible method is to ensure that the borrower has a significant amount of his/her money in the project or development etc. The point of taking this guarantee is so that the chance of moral hazard and agency issues arising is significantly reduced, the borrower is also far less inclined to default. In summary this has demonstrated another example of how an investor/institution can compensate themselves for a risk that they would otherwise not have taken.
There is a further procedure that can be carried out in order to compensate someone who would not normally take risks. This is to reduce the impact if the risk actually does occur in the future. Before we even take the proposed venture/risk we should weigh up the probability of occurrence against the seriousness of the risk if it does occur. For instance, if the probability of occurrence is low and the seriousness of the risk low the investor/institution would obviously take on that risk.
At the opposite end of the scale, if the probability of occurrence was high and the seriousness of the risk high the investor would obviously not even consider taking on that risk. More importantly, we now come across the other two possibilities in this model. If the probability of occurrence is low, yet the seriousness of the risk high, it is very likely that this risk will have crisis potential. Therefore, an investor would be well advised to steer clear of these opportunities as he might from a high occurrence, high seriousness opportunity.
The final possibility is that a venture will have a high probability of occurrence but the seriousness of this will be low. In this final case the investor/institution can take on this risk but it must carry out the procedure discussed earlier of charging the right premium. Therefore, in assuring that the impact of the risk if it does occur is not is reduced an investor can be more comfortable with their lending. Thus, in reducing the impact on occurrence we have established another way to compensate the investor to take risks they otherwise would not consider taking.