Can any one please tell me the difference between risk shifting and risk transfer?
Risk Shifting:
Occurs when managers make overly risky investment decisions that maximise shareholder value at the expense of debtholders’ interests.
Two scenarios can occur: these risky investments payoff or they fail. In either case, sharholders’ claims are only satisfied after debtholders claims are satisfied. So if the risky investments payoff, debholders get their prior ranking fixed claims and the extra upside in the value of the firm (as a result of taking on more risk) accrues to shareholders. If the risky investments fail, eventhough debtholders have a prior ranking claim, these claims run the risk of not being satisfied.
Equity holders are compensated for the risk of investment by a higher required rate of return compared to debtholders. But the more risky investments the firm takes on, the debt holders’ interests may be compromised because they essentially take on more risk for no additional compensation - they are promised the same payoff in both cases and don’t enjoy the upside if the risky investments payoff.
Risk Transfer:
Occurs when the risk of loss is transferred to another party. For example, Insurance companies charge you a premium and in turn bear the risk of some loss you may face over a given period. You could invest in a company bond and buy protection on that bond’s periodic cashflows (if the bond issuer defaults/does not pay) via a Credit Default Swap (CDS) written by a thirdparty. The writer/seller of the CDS will demand periodic premiums (compensation) for offering you protection against the bond issuer defaulting.
They sound quite similar, but a key difference I suppose is that in Risk Shifting the debt holders aren’t readily willing to take on the additional risk the firms shift to them since they are not compensated for it. Whereas in risk transfer, the parties who take on the risk are willing and able (you’d hope in most cases…) to do so and receive appropriate compensation for taking on that risk.