Sometimes wrong situation arising. The investor can cover
Sometimes there may be risk that the lender is just not prepared to take, this is more than likely because the lender is too risk averse. However, there is still a way that this lender is able to put forward their investment, and this is by shifting the risk away from themselves. Taking insurance on a loan that you are issuing does this. Costly as this decision may be the lender can be comfortable and fully compensated in the knowledge that they are not taking any risks whatsoever. Nevertheless, this must obviously be weighted against the loss in profits that the lender will be incurring.
Only an insurance firm has the ability to accept such offers due to the fact that it has economies of scale. The insurance firm also counts on the law of large numbers. For instance, the insurance company knows that only fires will destroy a very small number of houses each year, and due to the fact that it has insured a very large number of houses it has spread the risk. The insurance company is able to diversify risk to a much greater extent to those that seek the insurance. Of course, insurance companies will not insure anything and certain loans can be very hard to insure.
This is due to the fact that there is asymmetric information between the lender and insurance company, furthermore there may arise a moral hazard if lenders know that they will be able to get all risks insured. Thus, we have discovered yet another way that investors/institutions can compensate themselves for taking risks. This is an expensive option but it cannot be overlooked that it fully compensates the investor and eliminates all risk from the lending. Closely linked with the topic of insurance are the more complicated options and forward contracts.
In buying a futures contract a lender can be open to changes in the value of the future and can stand to make a significant loss given the wrong situation arising. The investor can cover himself of this risk by purchasing futures that are guaranteed to be at least equal to the investing price on the future date. For example, a company with a commitment to pay a foreign supplier of goods in three months time will be at risk to fluctuations in the exchange rate. However, the company can protect itself by purchasing forward the currency at an agreed price, but for delivery still to take place at the same time.
With options contracts the lender can do the same thing except that he/she will have to pay a premium in order to have the option to transact at a set price at a future date. It is up to the investor whether he/she exercises this option and they will base their actions on the current market price and whether it is higher or lower than the agreed price from the outset. In these two examples the lender has compensated himself for taking the risk at the outset of the transaction and can guarantee that they will not stand to lose significant amounts of money.
Finally, the last way that the lender can protect themselves in the event of a risk occurring; is the method of the lender making themselves able to absorb risks financially. There is more than one way a lender can prepare themselves for this. Firstly and probably most obviously the lender can set aside capital for any risks that do unexpectedly occur. Banks for instance will always have fairly significant capital reserves to cover their uninsurable risks. Thus, the bank has re-assured itself that in the event of a risk occurring, they are covered financially.
The second way that the lender is able to compensate themselves and absorb risk is by the usage of risk pricing. This is linked with the charging of risk premiums as previously discussed. From experience, lenders will know that a borrower who keeps up with repayments will more than likely not default on their loan. At the opposite end, a borrower who is constantly late with repayments is the most likely candidate to default on their loan. Thus, to deal with this problem, the lender can charge an increasing rate of interest to those that are not keeping up with their repayments.
Those who make repayments on time will be charged the lesser rate of interest. The theory behind this practice is the poor re-payers are an expected risk (we expect them to default) and therefore the lender should charge a risk premium with significant profit before the anticipated default. In this final example we have found another way for the lender to assure and make their position more comfortable in lending, they are once again compensated for taking risks they otherwise would not have taken.
In summary we have a comprehensive discussion of how investors can cover themselves for taking risks that otherwise they would not have even considered. In response to the initial statement I would come to the conclusion that it does have substantial empirical evidence to back it. On a whole investors are risk averse but they have methods to put into practise so that they can become more adventurous and take greater risks whilst still safe in the knowledge that their money is safe and they do not stand to make a great loss on their money.