Money $marts: No free lunches in risk return trade-off

Many smart economists make financial market predictions. Some are famous from media appearances. Few are rich. Predicting is easy. If done often enough, a forecast may come true. Betting on them is hard.

If done often enough, you can go broke. Economists are well aware of the concept behind this phenomenon. It's called risk. That's why selling advice is more lucrative than acting on it. Risk premiums are this month's School Daze lesson.

With abundant and freely available information, financial markets are adept at assessing and charging for risk. Thus, all transactions incorporate the risk concept through the inclusion of premiums; the higher the risk, the higher the premium. For example, The U.S.

government borrows money at a risk free rate since default is assumed impossible (it prints the stuff). All other borrowers pay higher rates. The most credit worthy corporations (rated AAA) are quoted rates of U.S. Treasuries (T) plus basis points. T+22 would indicate a rate of say 6.22 percent compared to 6 percent. High risk corporate borrowers pay more, say T + 500 (11 percent) in the "junk" bond market.

Risk premiums can be minimized by providing security (collateral) giving the lender an alternative means of recovering money. Premiums can also be reduced by the "law of large numbers". Statistically, it is easier to forecast the number of "events" out of a million identical transactions, than just one. The chance of any individual dying in a year is much less predictable than the number of deaths in a million. Insurance companies can figure affordable premiums through these statistical calculations.

Consumers pay risk premiums on all loans. Higher premiums reflect weaker credit histories as indicated by credit scores. Sometimes, however, premiums exceed the real risk. Many credit cards, for example, bear interest rates that cannot be risk justified. In the absence of usury laws (illegally high rates) little can be done save shopping for a lower rate.

The most important aspect of risk premium knowledge is the avoidance of scams. Any deal that promises a high rate of return with little risk should immediately be suspect. Free lunches do not exist.