Natural persons who have medium of exchange balances after a production period do so because they wish to consume in the future. This is either because they want to reduce the time they spend providing labor or because they wish to obtain land, production functions or services that will improve the quality of their labor. Retirement and reserve for periods of illness or disability are some of the main concerns addressed by retaining medium of exchange for future consumption periods.
There are others who have plans that can not be executed because their plans require that they have control over resources to which they have no ownership rights. These plans could be to purchase a house, car, furniture, etc. or to improve or create a new production process that it is hoped will result in a profit.
In any of these cases, the natural person will seek others, who promise in exchange now to return over an agreed upon time span medium of exchange payments until some agreed upon termination date when the agreement will be considered satisfied.
The person with excess medium of exchange, instead of exchanging it for land, labor or production functions now in the spot market, is exchanging it for a promise called a financial product. These products can be equity, debt, insurance or hedges. The future is unknown but not unimaginable so there is always an element of risk in these promises. The risk can be classified into two categories: credit risk and interest rate risk.
Credit risk is the probability that the person making the promises fails to fulfill them either in part or completely. This risk can result in the promised amount of medium of exchange not being repaid. Government enforces properly drawn promises. Failure to make payments will result in civil and possibly criminal actions if fraud is suspected. Many promises are drawn up such that if there is a default, the creditor will have rights to the borrowers assets which secure the promise.
Another type of risk involved with financial products is that interest rates will change over the term of the promise. This does not, in general, have the potential for a loss unless the promise was made by a bank or other financial intermediary that mismatches the terms of the liability with those of the asset; for example, if a bank lends money for 5 years at 5% then pays depositors 3%, with 2% reserved for bank expenses, credit risk and earnings. There would be no significant interest rate risk if the 5 year loan were matched with a 5 year certificate of deposit. However, if the bank funded the loan with a 2 year 3%certificate of deposit and then, when the certificate of deposit matured, issued another certificate for the remaining period, it would be exposing itself to the risk that it would need to pay more or it would default on the first certificate of deposit. It also could possibly fund it at a lower rate and earn more. Generally, short term interest rates are lower than long term rates- a positive yield curve - so banks tend to lend long and fund short. Since banks generally mismatch their portfolios, they put a strong pressure on the central bank to force short tem interest rates down by creating more medium of exchange. This results in savers losing purchasing power.
Once a transaction is made and all parties fulfill their parts of the agreement, there is another risk. This is the risk that a better investment could have been made. For example, you put part of your savings into a firm that doesn't perform as well as another but still fulfills all of its promises to you.
There are two general types of financial instruments that are issued: debt and equity. Debt in general is secured by some sort of collateral and has a fixed term and fixed interest payments. Equity is ownership shares in a corporate person and has no fixed term or fixed payments. Instead it entitles the owner to participate in the management and earnings of a corporate person.
From the economic point of view, secured debt is intended as a means of financing items that a natural person intends to own such as a house, car or furniture. Inventory, machines, vehicles and other items of land that can be used as collateral are candidates for debt financing for a corporate person. The transaction is that the person agrees to make a fixed set of payments over a period of time that will pay back the amount borrowed plus interest. The borrower also pledges specific items as collateral, which the lender has the right to posses if the borrower does not fulfill the promises made.
Unsecured debt financing is based on a promise to pay fixed amounts of money over a period of time from the general resources of the person borrowing the money. Since there is no specific use for the debt nor is their collateral pledged, this type of debt is more risky and commands a higher interest rate to cover the additional credit risk.
Both the corporate person and natural person will need earnings to cover the interest and principal payments. Taking on debt exposes the person making the transaction to bankruptcy, and the owners losing their investment to the creditors.
Equity from an economic point of view is the means by which corporate persons are initially funded. An entrepreneur prepares a business plan, then promises to pay the earnings of the corporate person to the natural persons or corporate persons who agree to contribute medium of exchange, land or production functions to the new corporate person in exchange for a proportionate right of ownership. These owners are called stockholders.
Projections of future earnings and requirements for land, labor and production functions are made. The funding issued as equity is priced based on the present value of the projected earning stream. If this is greater than the amount the entrepreneur needs to get the business established, then the corporate person is potentially viable.
Subjective value and the level of savings are the final determinants that the entrepreneur must face to actually sell enough equity to form the corporate person. Equity does not expose the owners to bankruptcy. Equity financing allows for a winding down of the enterprise in a way that can preserve the residual value for the owners.
Insurance is a financial product which pays the insured if some random, rare but unaffordable event to the insured occurs. If the cost of the rare event can be spread over a large pool of insured, then the cost of the event may be affordable on average, but not alone, for any of the insured. If an event is predicable, then it is not insurable. Insurance is also not necessary if the event is affordable. An example is payments for retirement expenses.
If an individual at 65 has an average of 20 more years of life and has the possibility of an absolute maximum possible lifespan of 105 years, then the retiree has to have sufficient funds to cover expenses for 40 years for peace of mind. Clearly an annuity, if it could be purchased for a reasonable cost from a reputable firm, would be of interest to those who only had funds to pay for 20 to 40 years of expenses. Those with funds to pay for more than 40 years of expenses would be better off to not buy an annuity and save the administrative and credit risk costs. Those with less than 20 years of savings for expenses would need to work longer if they were to have peace of mind and not have the probability of depending on charity for their support in retirement.
Similarly, serious accidents or illness are rare but predicable events over a large population and can be insured against before they occur. Once someone has an illness or accident, they are not insurable for that illness or accident because the insurance company would need to charge for the cost of the treatment plus expenses and would only have the pool of people with the problem to charge. This is why it is imperative to have a system in which this type of discrimination can not occur or a person and their family will be destroyed by the unaffordable cost of treatment. Insurance, to be effective in lowering everyone's cost to the average cost, needs to be spread over as large a population as possible.
Hedges are a form of insurance. They ensure that a certain price for an item in the future will be obtained. Classically it is achieved through a forward or future contract. One party agrees to sell to another something at a date in the future instead of now in the spot market. This technique is used by farmers, for example, to ensure that they get a minimum price for their product that covers production costs and their earnings. The other party to the transaction, for example, a food processor, knows what the cost of the ingredients is, allowing them to plan and issue price lists for their products. Each party takes on risk -- the farmer that he or she could have gotten a better price in the future and the food processor that it could have gotten a lower price. A third party such as a futures exchange may also be part of the transaction. The third party's role would be to facilitate and guarantee that the transaction occurred as intended.
Lending and borrowing are ways that allow persons to provide for future consumption and finance activities that provide for improvements to their standard of living. This is done by purchasing financial products with their medium of exchange that is not used for current expenditures. These financial products are classified as: debt, equity, insurance and hedges.
Copyright 2014-2019 Richard A. Cornell, PE