1. Large businesses spend millions of dollars annually on insurance. Why? Should they insure against all risks or does insurance make more sense for some risks than others?
Businesses spend substantial money on insurance to protect their assets. The loss of assets costs them money, and the insurance is a hedge against those costs. If they suffer property damage, it will cost money to replace that property, and if the property is necessary to the business's operation, it will cost them in down time, as well. Businesses need to protect against losses to preserve both their assets and their cash flow. An emergency that requires a huge influx of cash to correct can derail a company that might otherwise flourish, as it reduces working capital.
Businesses do not need to insure against all risks. For one thing, insurance is a cash drain in itself, and insuring some risks makes more sense than others. Insuring against property damage is essential, but specialty insurance such as insurance for floods is only valuable if the business is located in a region that gets flooding. A business in Arizona, for example, probably does not need flood insurance. Insuring against conditions that precipitate a loss of business is worthwhile. For example, if a business depends upon street traffic for its customers, a longterm street construction project could put it out of business, so insurance to cover that contingency is advisable.
2. Speculators want futures contracts to be incorrectly priced; hedgers want them to be correctly priced. Why?
Speculators want futures contracts to be incorrectly priced because they are not looking to purchase them but to make money off the risk. Hedgers want them to be correctly priced because they want to purchase them. The hedger wants to lock in the current price to hedge against a future rise or decline in price, while a speculator wants to lock in the current ...