Risk and Financial Institutions

Abstract

The modern theory of risk owes its origins to Keynes (1936) and Hicks (1939). They propounded the theory of liquidity preference, arguing that, other things including return being equal, investors prefer liquid assets of certain value to illiquid assets of uncertain value. This allows them to meet potential and unforeseeable demands for funds. Thus investors require an additional return, known as a risk premium, on assets whose price varies, in order to compensate for the uncertainty about the price that such assets may command at any time. It was also argued that borrowers would prefer long-dated liabilities which require fixed interest payments for the duration of the debt. This means that, for the life of the loan, they face known interest payments and that they can make, well in advance, the arrangements necessary for its repayment. Indeed, if borrowers did not have reasons for preferring long-term debt, there would be no market in such debt. Private borrowers must be prepared to pay the premium demanded by the lenders.