I discuss a new derivative this week that can benefit the space industry. Check it out!
VIDEO SUMMARY
I have been working on this idea for a couple of years now, and I thought I would just share it and see what people think. So in this video, I am going to talk about my design for a new exotic financial derivative.
This is going to be a more advanced video. If you need a basic introduction to financial derivatives, I actually made a bunch of videos that cover the basics. Even if you just need a refresher on the subject, you can check those out on my YouTube channel or my website. I will leave the links for that in the description below.
VIDEO: What are Financial Derivatives? https://wolvesmainsite.wpengine.com/weekly-video-what-are-financial-derivatives/
VIDEO: Types of Financial Derivatives: https://wolvesmainsite.wpengine.com/weekly-video-types-of-financial-derivatives/
I designed a financial derivative. And financial derivatives normally exist for a specific business reasons. So I think that is a good place to start with the business problem we are trying to solve. The issue we are going to focus on deals with the Commercial Space Industry. The Commercial Space Industry is made up of companies that enable us to work, travel, and play in outer space. There is an interesting dilemma facing rocket launch providers, and it deals with space insurance. If you were going to launch a rocket into space, your cost to insure that rocket is very expensive. Launching rockets is a fairly risky business. The risk of failure during a launch has been around 20%. Personally, I believe that number is going to drop dramatically over the next couple of years. However, historically risk has been around 20%. But that is not the only reason why insurance prices are so high.
The real problem faced by insurance companies, is that the business model of a rocket launch provider contradicts the business model of a traditional insurance company on a fundamental level. The way insurance companies work, is they spread risk out over long periods of time. If you wanted to insure a building that was going to be around for forty years, the insurance company can spread that risk out over forty years. This is the same way health insurance works, and car insurance. That is the reason why insurance is so affordable. Even if the potential risk could be very expensive, your annual payments are so low because they are spread across long periods of time and many different customers.
What is different about a rocket launch company is that a rocket launch lasts a matter of minutes. You will know within minutes whether your launch is successful or not. Well, from the perspective of the insurance company, that is a problem, because you do not have a period of time to spread out your risk payments. So if a rocket launch company wanted to insure their rocket, they would have to pay all their risk payments up front, which results in high insurance payments.
If you look at the space insurance industry today, you can see these issues playing out. The insurance companies are having a hard time collecting enough market premiums to cover the insured value. When you ask the insurance companies what is going on, they say that there is not enough market demand to pay high enough prices to cover this risk. And that is what you see when you look at the rocket launch companies. Only about 50% of launches are insured. A lot of companies are choosing either to not insure or self-insure, because the prices are just too high.
The reason I am spending so much time talking about this, is that insurance is really important for a well-functioning economy. Imagine what would happen if 50% of people did not have car insurance. If you ever got in a car accident, you would have very real concerns with how you could financially manage that situation. The reality in the space industry is launches are going to fail, and we need insurance markets to keep the industry going. If there ever is a failure, it should be a simple transaction to send the insurance money to the rocket scientists to have them start building the next rocket, and keep the industry going. So insurance is really important.
So what if I told you I had a way to dramatically lower the cost of insurance for the whole space industry at no up-front cost for the rocket launch companies and very little risk. My recommendation to solve this business problem is to create a new financial derivative. I call this derivative a “Rocket Swap.” Ultimately, what we are talking about here is risk. Financial derivatives are really great at moving risk into capital markets where people are willing to hold that risk. The reason why I call it a Rocket Swap is because it is very similar to a Credit Default Swap (CDS). A Credit Default Swap was created by JP Morgan in 1994, and it is now a capital market worth trillions of dollars. It is an agreement that you will pay off a loan if it defaults. Every time you have a loan, either two things will happen: it will get paid off or it will default. There is a binary situation, and based on the outcome, the Credit Default Swap will kick in. Well a rocket launch company is also a binary situation. Either the rocket launch will be successful or it will be a failure. So a Rocket swap is a financial derivative that removes the risk from the rocket launch company to capital markets where they are willing to hold that risk for a reasonable return.
I have run a number of simulations on how this would play out and the outcome is impressive. I will give you a short list:
- The cost of insurance drops dramatically.
- Rocket launch companies have no up front cost.
- Banks never lose. There are multiple tranches and the AAA Tranche receives guaranteed payback.
It is a little bit more complicated than this. I am simplifying it down. But it is a true win-win situation, because you are moving the risk in a way where everybody benefits. The rocket launch company benefits. The investment bank benefits. Everybody is better off. The reason why all this works is the unique quality of rocket launch companies, that the launch outcome is known in a matter of minutes. The short time duration, which is difficult for traditional insurance, is the very thing that makes it so attractive for financial derivatives. If you are purchasing an investment for a matter of minutes, you can afford to take a very small return. Because even if you are only getting pennies on the dollar, if you can turn around and do multiple launches in quick succession, and get a return on every launch, you can quickly make a lot of money, even at 20% risk. That is how the cost to insure these rocket launch companies would drop so dramatically.
There is a scenario that would be problematic, and that is called a Black Swan Event. This would be a very unlikely situation where the risk profile changes. For instance, if rocket launch failures suddenly increased from 20% to 50%, that would be problematic. But statistically, that is so unlikely that it is almost not even worth talking about.
The reason I am convinced about the benefits of Rocket Swaps has to do with the history of finance. The first financial derivatives were created for farming. Farmers started buying forwards and futures to protect against the risk of changes in crop prices. So in the same way that farmers used derivatives to remove the risk from farming, Rocket Swaps would allow the space industry to remove the risk from rocket launching. I am not selling anything here. Rocket Swaps do not exist, and this is all theoretical. All I am doing is pointing out a huge opportunity in the market place.
Leave a comment down below letting me know what you think!
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.