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Financial Security

Financial Security. Rent or not to rent, that is the question. You own a small apartment You can rent it for a year at $5,000 per month for a year while you go to Spain for a year But, your apartment is full of stuff You can store them for $3,000 per month You know the person who will rent.

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Financial Security

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  1. Financial Security

  2. Rent or not to rent, that is the question • You own a small apartment • You can rent it for a year at $5,000 per month for a year while you go to Spain for a year • But, your apartment is full of stuff • You can store them for $3,000 per month • You know the person who will rent

  3. Rent or not rent • Two alternatives: • (1) Rent for $5,000 per month and earn $60,000 during the year but you also have to store your stuff • (2) Not rent. • [Ignore tax, deposit, legal aspects of renting…] • Using an initial wealth level of $50,000 what would be the best decision?

  4. Decision • Rent : U(50000 + 60000 − 36000)=U(74000) • Notrent : U(50000) • For ANY utilityfunction, thedecisionisclear • So far, no risk • Supposethattherenterwill NOT paywith a probability of 0.25. Wheredoesthis0.25 come from? • From personal experience • Itissubjectiveprobability: Previousexperience of theperson

  5. rent 14000 .25 .75 74000 Not rent 50000

  6. This time we need a form of U • 0.75U (74000) + .25U (50000 - 36000) • = 0.75U (74000) + .25U (14000) • U(w)=ln(w) • Notrent: U (50000) = 10.82 • Rent: 0.75U (74000) + .25U (14000) • = 0.75 . 11.21 + 0.25 . 9.54 • = 10.79 • You are better off notrenting.

  7. Conclusion • Theexistence of uncertainty/risk has madeitdifficulttorent • Thisrisk has madeboththeconsumer and producerworse off: Renterwouldratherrentbutyou (producer) are afraidthattheywillnotpay • What do we do? • Onesolution: We can increasetherent • Findtheminimumrise in rentneededtomakerentingprofitableagain

  8. Other alternative • Supposesomethirdparty comes and offersyouthefollowing: • Iftherenterdoesnotpay, theywillreturnyourrent 100% • Itis NOT a free service, theywillcharge$1,000, whetherornottherenterpays. • Thisis a new transaction • Willyounowrent?

  9. rent .25 .75 Not rent

  10. Alternatives now • Not rent: U (50000) = 10.82 • Rent: 0.75U (50000 + 60000 − 36000 − 1000)+.25U (50000 + 0 − 36000 − 1000 + 60000)= U (54000) = 10.89 • Question: What is the maximum the third party can charge so that you still would rent?

  11. Financial Security • Whathappened in thisexample? • This new contractperfectlyhedgesagainstthepossible default bytherenter • Theowner has a contractwith a thirdpartytoexchange a FIXED smallamount ($1,000) in exchangefor apotentiallylargeamount ($60,000) thatispayableunlyiftherenterdoesnotpay. • Nowthiscontractallowstherenter and ownertorenewtheircontractviathiscontingentcontract • Itbenefits ALL threeparties

  12. This is called a surety bond or a “fianza” • A surety bond or surety is a promise to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract. • The surety bond protects the obligee against losses resulting from the principal's failure to meet the obligation. • A surety bond isanexample of financialsecurity

  13. Surety bond • A surety bond is a contract among three parties: • The obligee - the party who is the recipient of an obligation, • The principal - the primary party who will be performing the contractual obligation, • The surety - who assures the obligee that the principal can perform the task

  14. Some exercises • Whywouldit be attractiveforthecompanytogetintothisbusiness • Howwillit produce profits?

  15. Financial Security Financial security is achieved by building a series of networks that can operate so that the players can have their obligations fulfilled This has the effect of promoting economic development Actuaries are in the frontier of developing such instruments.

  16. $ With Security Without Income over time What is the cost of reducing variability? Is it free?

  17. Examples All contract networks All Insurance contracts Fianzas Social Security (financial/health) Pensions Risk management Financial transactions (banking)

  18. Pure risk When we have losses and losses (insurance company territory) W W-1 W-2 W-5

  19. Examples Buying and selling stocks Having a car Life Apartment rented Bond

  20. Requirements for constructing a system of financial security 1. A financial system where there is a potential for losing financial wealth 2. The losses have to be expressable in monetary terms 3. Measuring those losses have to have quantitative expression of probability 4. The system has to have some financial and legal guarantees

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