Risky business

/ February 10, 2014

risky-business_lThe other day, my brother told me how relieved he was at having been able to purchase a ticket to the United States for an upcoming business meeting. The price tag? BsF 21,000, which at the SICAD rate airlines will supposedly be getting comes out to roughly US$1,750, an outrageous figure. In fact, airplane tickets to Venezuela have been sky-high for years now.

This is not uncommon in Venezuela. More often than not, Venezuela is listed as one of the most expensive places on Earth. Now, there are a million reasons why this is so, but a big part of it lies with a concept that I try to explain to my students every semester: the price of risk.

Human beings don’t like risk. We dislike it so much, we are willing to pay money to avoid it, or we charge extra if we have to face it.

Let me give you an example: suppose I were to tell you about a game in which I flip a coin. If the coin lands on “heads,” you win $50. If the coin lands on “tails,” you win $100. To play this game, you need to buy a ticket. How much would you be willing to pay for it?

Surely you will pay at least $50 for it, since it’s the minimum you would be able to earn. But you will also, most likely, pay less than $75, which is the “expected value” of the payoff (equal to $50 times 0.5 plus $100 times 0.5). In other words, $75 is the average payoff, but you would be willing to pay a little less than that.

Why? Because there is risk involved.

If you were to pay $75, you will end up either winning $25 (tails) or losing $25 (heads). In other words, you end up in the same place you were before playing the game. Surely you prefer to pay a little less with the hope of making an (expected) profit, right? Otherwise, why play? Therefore, the maximum willingness to pay for the ticket lies somewhere between $50 and $75.

If that is true, the I, the “seller” of this game, find myself selling something that is “worth” $75 for slightly less than $75. That money I am giving up, that income I don’t make, is due to risk. Risk is costly – costly for the sellers, and costly for the buyers.

Let’s translate this idea to the markets in Venezuela. When the airline is selling you a ticket, it might have a promise to translate its earnings at the SICAD rate, but there is no guarantee. The SICAD rate could be devalued, or the government could simply refuse to give them access to dollars. Even the spare parts on its plane could be stolen. A million things could go wrong.

In order for the airline to be willing to sell in this highly risky market, it needs to be able to “cover” the cost of risk, just like you need to cover the cost of everything else – labor, transportation, etc. Otherwise, it makes no sense for you to sell in this market. Just ask Toyota!

In other words, there is considerable risk involved, and risk is expensive. Therefore, the airlines have to charge you extra to account for this risk. This is true for airplane tickets, for people lending money to Venezuela, and for pretty much everything else in the country. Whether it’s the risk of your goods being stolen, not having access to dollars, or even the risk of expropriation, the bottom line is that doing business in Venezuela is mighty risky, and consumers have to pay for that.

The government of Nicolás Maduro now has a law regulating every firm’s earnings at a maximum of 30%. In order to evaluate compliance with the law, it is supposedly going to evaluate the cost structure of each company, deciding which costs can be taken into account in order to set prices, and which cannot.

Whatever they decide, you can be sure that the cost of risk will not be an allowable item when estimating the maximum prices, which means companies will not be able to cover a huge amount of the cost they bear when doing business in Venezuela. In other words, they will be tempted to simply leave, which is why this law will only increase the empty shelves in Venezuela’s markets.

Brace yourselves.

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35 thoughts on “Risky business”

  1. Would this be related to the high Voldemort exchange rate? The seller is trading safe dollars (or heck, even pesos) for risky BsF, so he charges a lot for one dollar to make up for the risk

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    • Yes, that’s called currency risk, and it relates to the expected loss of value of a currency against another one, and it’s closely related to inflation expectations, market views, etc. If you add currency risk to black-market risk (transactions are less clean and with higher chance of default/fraud), that adds up to a significant chunk of the black market premium.

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  2. Excelent explanation of the impact of risk on prices !!, there are of course many different kinds of risks , one which is very prominent in Venezuela is that which affects the availability of foreign currency where ultimately payments have to be made to a foreign creditor in foreing currency , another also very important is the contingency that attaches to the calculation of the costs you will have to incurr in order to carry out your business in a profitable way. If you cant calculate the costs with any accuracy because they are subject to violent or drastic change then you have to make a provision in your accounts to be able to cover those unexpectedly higher costs , this provision will have to be higher the greater the chances that you will not calculate future costs with predictable accuracy , the amount of this provision is itself a cost . With the shortages and inflation now affecting the purchase of any item needed to carry out any business this contingency cost or cost risk provision has to be higher which translates it self into higher prices. Of course the risks attendant on the need to purchase unpredictably available foreign currency feeds the risk of contingency costs being more volatile in any production process dependent on imported items and thus motivates the setting of higher prices to cover the said risks .
    Of course risk is another way of referring to a different but interdependent concept , that of confidence, where confidence is short then its usually because the risks of a business are deemed to be high, there is nothing to hurt the confidence of businessmen than the actions of a govt which are totally whacko.!! Venezuela is certain to be anything but a businessmens paradise . the impact on prices is one which is evident to anyone having the msifortune of living there. !!

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  3. “you can be sure that the cost of risk will not be an allowable item when estimating the maximum prices, which means companies will not be able to cover a huge amount of the cost they bear when doing business in Venezuela.”

    That is the reality and thus most foreign operators will choose to wait it out until the rules of the game are clear again- and their debts are paid, of course!!

    PS. I hope it was a biz class ticket at least!!!

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    • I believe CIV assumption for a ‘Works Contract’ used to contemplate a 15% contingency component and a 15% profit component as standard. Adding the two you get 30% , might that have influenced the setting the maximum profit at 30% ?? Evidently where contingencies dont materialize they convert into part of the profit . Of course this standard was technically only applicable to certain sized Contracts under ordinary conditions and not to other kinds of contracts or transactions such as sales of goods , supply of technical services and the like .

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    • The Regulation to the Law just came out , and they make no mention of contingency costs in the calculation of the max allowable profit , moreover for most products/ services they cap indirect and overhead costs at 12.5 % of direct costs , which in many cases can be too low. Their one size fit all model is both unrealistic and irrational . The appear to make some concessions to retail marketing, still the fact that they make no provision for contingency costs in the calculation is a sign that they have no idea of how real business are run . Of course you can always figure that any contingency costs are taken from the profits . Another thing tributes (taxes) are not considered costs , which is absurd except for income taxes ( which are taxes on net profits) . Businessmen must prepare themselves to a kafkean roller coaster when they get visited with the ‘fair price’ inspectors , that or, a nice gift gets all problems solved !! With the Law they have made money making a presumptive crime in Venezuela !!

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  4. I read somewhere that American Airlines (AAL)—which flies to Venezuela from Miami, New York, Dallas, and Puerto Rico—says the airline has no plans to reduce its service and is working with the government to obtain its money.I wonder what working with the government means in this case?

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    • Well, they said that but they are not selling tickets. Working with the government means they are trying to get paid what they are owed. I heard that Avianca has been paid with gasoline and that’s why it is one of the few airlines still selling tickets (but only 1 month before the trip to avoid the CADIVI scammers bunch since you need more time than that to do the paperwork).

      Demand is so high Avianca is calling people to try to accommodate them on different flights and offering a voucher of 270$ if you switch flights, specially because certain times are a lot more sought after since people don’t want to travel on flights that make you leave your house at 2:00 am in the morning.

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      • Moraima,

        Our daughter told us yesterday that in order to buy a plane ticket you have to have private health insurance….do you know anything about that? I wonder if its just a rumor.

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      • My wife, son, and mother in law flew from Valencia to Miami yesterday. They reported that the flight was empty, although it had been fully booked. Cadivi provided ZERO dollars for my mother-in-law, although she had been approved prior to the change in the exchange rate. My wife was crying in frustration at the total lack of concern about the plight of an 80-year old woman trying to obtain a few hundred dollars by staff at the bank. I am guessing that other folks that held tickets did not fly due to the lack of travel dollars. Pretty hard to pay for a hotel if you have no money. If the goal is to keep people from traveling, then it is working.

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  5. JCN: “Therefore, the maximum willingness to pay for the ticket lies somewhere between $50 and $75.”

    Not for everyone. Gamblers use real world statistics, versus the theoretical probability that you are using, one of the reasons, following:

    Probabilities are what statistics *approach* with increased number of events (i.e., coin tosses, in your example). But with few events, it is very unlikely that the statistics matches the theoretical probability. Out of 10 coin tosses, the chances are not 100% that you’ll have 50:50, merely because you may get 6 heads and 4 tails. It’s not uncommon to get 10 in a row of one or the other within 100 flips. Gamblers know this, and take advantage of this by paying, say, $90 for a series of tickets, *until* they get a winning streak, then they stop and count their profits. Even if they get an initial losing streak, they keep going because they know it will even out in a longer run. In that case, they pull out when they break even. The key is to not keep pressing the luck after a winning streak, which is what addicted gamblers fail to accomplish. But the pros, they make a pretty mint playing the difference between probabilities and statistics.

    So, for someone making a short-lived business out of these tickets, they’d be willing to go over the $75 limit.

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      • J. Navarro, actually, they do know it, at least with the coin toss, because they know probabilities. They *know* that a winning or losing streak will tend towards a 50:50 chance in the long run. They know this with statistical precision, given a fair coin. And that is the key. If after a sufficiently long run the tosses do not tend towards the theoretical values, then they *know* the coin is not a fair coin.

        Case in point, a statistician began trying to test an analogous gaming strategy for roulette tables. The strategy was to always place bets on the number that had just come out on a roulette table on the previous roll. The basis for the strategy was the observation that numbers seemed to repeat themselves more than intuitively expected. The tests showed that the results were not tending towards the theoretical equal chances for all numbers. It turns out that what was being observed turned out to be the natural wear of the roulette wheels creating invisible tracks that the ball would follow onto certain numbers more than others, in effect making it a not fair wheel. Since then, large casinos change their wheels more frequently. The not so large casinos often buy the used wheels, so your chances at winning at these old casinos is higher if you always bet numbers that have recently come up.

        Granted, in the airline ticket thing, the gamble is riskier because there is no pure, theoretical probability against which to measure results. But neither are there pure, fixed rules. So in the ticket situation, the gambler has the incentive to play the “unfair” coin game, so the incentive is to get on the “in”. This is what the non gamblers will call a form of corruption. The end result, however, is that the pro gamblers are willing to go a little higher than the theoretical maximum of 75.

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        • “They *know* that a winning or losing streak will tend towards a 50:50 chance in the long run.”

          To paraphrase wikipedia: With any large number of flips, the proportion of heads vs tails approaches 50-50 (the Law of Large Numbers). But the difference between heads and tails needs not systematically decrease to zero.

          Which I understand as a losing streak not being guaranteed to even out at the end. That’s the risk.

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          • J. Navarro, I interpret that quote differently. They are stating that it *does* even out at the end, just not *systematically*. Casinos know this, which is why they don’t worry about the short run gamblers winning, since casinos count on the long run evening out. They *know* the numbers even out, so long as the play items are fair.

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              • J. Navarro,

                There is a breakdown in communication somewhere. I agree with you that each toss is independent to all previous tosses; there is no accumulation of probability. Pro Gamblers are well aware of this. It’s the non pros that fall for the fallacy, and don’t quit after a losing streak, because they believe it’s got to turn around. They also believe in winning streaks that won’t end. Pro gamblers believe the opposite of the fallacy, that if something happens it’s more likely to continue happening. That was the basis for the roulette study which was able to determine how the pros had been using to make money for years, that the tables in fact were not fair after repeated use. But they also know that the only way to determine if a table *is* fair, is statistically.

                Let’s use the simpler coin toss example. How many tosses will it take of twice as many heads than tails for you to decide that the coin is unfair? In theory, that can happen for any number of events, even large numbers, for any fair coin. But in the real world, there are statistical tables for determining within a range of confidence the amount of deviation away from 50:50 to allow before considering a certain scenario unfair. Statistics are used to determine fairness based on the *non systematic* expectation that in the long run, the numbers *do* even out. Whenever they don’t, action is taken to “correct” the assumed problem.

                Let’s look at it from the house’s point of view. The house never loses is a false statement if you look at each bet. But, over time, the house never loses because they know that wins are countered by losses very predictably, and quite precisely. It’s not that casinos fall for the fallacy; they are quite aware of the fallacy. In fact, they get to limit how many wins or losses can happen in a row, either by changing the hardware, or changing the rules. For example, on the roulette table, they limit the size of bets so that anyone using the doubling bet technique fails after a run of 5 or so losses. That’s the house’s edge against that strategy. They will immediately end any given wheel’s use after someone wins too much at a particular table, regardless of how new the wheel is. That’s just a precaution against the possibility of “unfair” hardware. In fact,they change the croupier often as a preventive measure against uneven wear.

                The Nevada gaming commission doesn’t fall for the fallacy either, but if a casino starts showing greater than certain percentages of winnings at some activities, they will investigate because, even though it is possible that the casino is simply having a good run, with such large numbers it is too unlikely. For this reason, a casino will even replace a roulette table if the house is winning more times than expected over too long a period, in fact, *especially* if they are winning more times than expected.

                It’s not that all these people, the pros, the casinos, and regulators are all falling for the fallacy; it’s that the real world has to be measured according to statistical expectation *as if* the fallacy were true, because sometimes it’s pure chance, but usually, it’s an “unfair” link in the chain. So, in the real world, pros will sometimes go over the $75 that pure probabilities would indicate, and they’ll make money off of it.

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    • I tested your hypothesis but it didn’t pan out. I build a program that would flip a coin 1000 times, making $1 with heads and -$1 with tails and that 10 straight victories would cash in.

      I ran the simulation 100000 times, and the results were close to 0 (-0.02514, -0.04539, 0.1206) to make any strategy irrelevant.

      if I changed the value to 49% chance of winning, then the result was -16 on average per run.

      I think the difference is that when you quit after a winning streak at the beginning you do are ahead so it gives the impresion of being a successfull . But the chance of winning 10 times in a row is much less than expected, and the great majority of runs finish the 1000 thousand attempts without ever cashing in.

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      • JFE,

        You used a computer algorithm that simulates probabilities. Computer algorithms are designed so that they *always* seem random. Try a real coin. I have personally done it and seen for myself that real world coin tosses seem less random than computer simulated coin tosses.

        Also, if you quit near the beginning after a winning streak, it’s not just an impression of being successful; it *is* being successful.

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      • JFE,

        I’m reminded of card shuffling algorithms. If you use a random function for shuffling cards in a Blackjack simulator, you will find that the cards get shuffled unrealistically random. In the real world, a hand shuffle, especially at a casino where they dealers are trained to do the shuffles in a particular way, is not random at all. They will always take close to half of the deck off the top and shuffle it against the bottom half. The cards that were at the bottom therefore have a higher probability to still be at the bottom after a shuffle. The cards that started at the top also have a higher probability to remain at the top. This is true even after a few shuffles. The series of shuffles then ends with a cut. The cut then moves the cards that started out at the bottom to somewhere in the middle, and the same for the cards that started out at the top.

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  6. Google lets you quickly compare prices for a CCS-IAH-CCS (probably priced at the official x-rate) and IAH-CCS-IAH to see the risk cost.
    https://www.google.com/flights/#search;f=CCS;t=IAH;d=2014-02-26;r=2014-03-05
    https://www.google.com/flights/#search;f=IAH;t=CCS;d=2014-02-26;r=2014-03-05

    Unfortunately education all over the world teaches young people that paper money is valuable. It really is just fancy paper, the economy behind the currency creates the value. They should stop creating the idea that the value of paper money is intrinsically solid.

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  7. JC just a little suggestion re: the new mobile website design, you can’t read the comments on the comments as the background is dark grey on the sides and the letters are in black. They also get thinner ending up as one letter per line as more people comment on each other’s comments!!

    Sorry for complaining, but I just can’t read them!

    Keep up the excellent work!

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