Question

1.        Josh hires Sandra to replace the guttering on his house with copper guttering. The price of copper increases by $2000 and the contract is silent on price inflation. Josh refuses to pay the extra $2,000. Now suppose that Sandra knows that there is a probability of 0.5 that copper costs could rise by $2,000 and that she could have hedged risk for $400. Who is the low cost risk bearer? If the risk was foreseeable; how might the contract accommodate the risk?

Answer 1

The expected cost of rising of copper guttering = $ {( 2000 * 0.5) +( 0 * 0.5)} = $ 1000

Sandra can hedge the risk for = $400

Here we can see that, Sandra is the low cost risk bearer.

Reason: Josh has to pay $ 2000 extra if price rises but Sandra will have to pay just $ 400 and she can hedge the risk.

How contract can accommodate:

In the case of forseeableness of risk, in the contract both will agree to the following terms:

1. Sandra will hedge the risk on the cost of $ 400.

2. Josh will pay Sandra $ 400 for hedging the risk.