Article Detail

Breaking Through Risk Management, a Derivative for the Leasing Industry

Journal 34: Cass-Capco Institute Paper Series on Risk

Sylvain M. Prado, Ananth Ram

In the leasing industry the lessor faces the risk, at the end of the contract, of not being able to recover sufficient capital value from the resale of the asset. We propose a financial product to hedge residual value risk. Furthermore, we discuss the contributions of derivatives to risk management.

In 2000, a group of Parisian economics students funded the movement for “Real-world” Economics to contest the usual approach of economic orthodoxy: a limited concern for the relationship between the economic theory and the real world. The students argued that concepts like the representative agent, the maximization of a utility curve, or the Efficient Market Hypothesis (EMH) do not help in getting a better understanding of the economy.2 In 2001, the movement was supported by Cambridge students; they published a manifesto, “Opening up economics,” which was signed by 797 economists. Forums were organized and new reviews were created all over the world to propose a different approach to economics. Within economic institutions, however, nothing happened.

Shojai and Feiger (2011) showed that the 2008 crisis had no effect on the economic mainstream despite the fact that it dramatically highlighted the irrelevance of the economic theories. The main reviews were still publishing articles with no value in the understanding of the real world; they were still using oversimplified models and irrelevant concepts like the EMH. Bernard Guerrien [Guerrien and Gun (2011)], a Sorbonne economist and one of the founders of the Post-Autistic movement, concluded that “unfortunately, discussions focused on the validity of EMH will probably continue, and confusion will persist, with time and energy lost in vain.”

Following Mark Planck, do we have to conclude that “a scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die and a new generation grows up that is familiar with it?” And, all things considered, do we really have to worry about these theoretical problems?

Unfortunately, we should be genuinely worried about serious failures in a specific field of applied economics: risk management. According to Shojai and Feiger (2010), risk tools and concepts are of no use to improve the survival of companies or the economic system. Built over non-relevant assumptions, they do not really manage risks. Mainstream economists can reply that it is easy to criticize, but to propose new practices and innovative solutions is something altogether different.

We aim to illustrate another way to practice risk management. We pro-pose a new financial derivative allowing for the management of residual value risk and providing a real value to the economy, not only a new mechanism for speculation or a fee generator for investment banks.

Moreover, this article is intended for people within the leasing industry interested in an innovative financial product, as well as people from the financial markets concerned with leasing risk opportunities. To be more specific, we aim to hedge residual risk on operating lease contracts.