Transfer Of Nuisance Risk

Every business carries out mainly two types of activitiescore and non core. The business exists and derives its profits mainly from the core activity. However, it has to carry out the non core activities since they are inherently linked to the core activity.

The non core activities could be called nuisance activities and the risk arising out of them could be called nuisance risk. If these nuisance risks can be transferred to others willing to take such risks, at a cost, it will be much more easier to operate the core business. The concept of transfer of ones non core activities and attendant nuisance risk gains ground once the economy becomes more sophisticated.

 

Ten years back, an importer of white goods would have been at a loss to differentiate the non core activity of managing forex risk from his core business of getting the best quality goods at the cheapest prices from the international market; and selling and servicing them efficiently in India.

If the importer were aware, he would like to transfer this nuisance risk to somebody else at a cost so that he can concentrate on his `core competence. Forward cover on foreign currencies, the simplest of derivatives, are available now to him through which he can transfer the risk at a cost which is called forward premium in Indian forex market today.

In the capital markets, mutual funds realise that managing share certificates held by them is a nuisance activity and therefore it is better to offload it to the custodians at a cost. This allows them to concentrate on the fund management and do more business. On the other side, for custodians, managing share certificates are their core business activities.

However, in many capital market related activities, the concept of nuisance risk is yet to be appreciated. Importance of specialization by market participants and transfer of nuisance risk should not be underestimated in the changed capital market scenario.

Indian capital markets have transformed substantially in last three years due to regulatory and market related innovations. The pace of change is going to be even more, given the technological innovations. To keep pace market participants will be forced to identify their core competence rather than trying to learn and carry out all the activities themselves.

There will also be ways available to divide a single activity into more basic components and specialization will happen even in operating in those basic components. For example, underwriting activity will have two risk componentsidentifying good issues on the basis of fundamentals of the issue, and risk arising out of market movements. Here, the core business is identifying a good issue which will get subscribed in normal times. The risk of issue not getting fully subscribed due to market conditions for subscription is a nuisance risk for him. Once the index based derivatives are introduced, he will be able to transfer this nuisance risk. He will sell index futures in a proportion where he will not be hurt by the losses due to develop-

ment as they will get offset by profits in his index future position. This strategy, however, will not save him from losing money if he selects an inherently bad issue, as the risk related to identifying a fundamentally sound issue is not being

transferred. This is just one example. In many more ways, nuisance activities in capital market will be identified. There will be participants available to assume these risk and a market for transferring the nuisance risk at a cost will come in place. A critical tool in the equities market will be futures and options. F&O are instruments to transfer risk from parties unwilling tosarily of his employer.)