Question

Explain how principal-agent theory can help our understanding of exchange risk./ 3.

Answer 1

answer-

let's first discuss what is principal-agent theory is. The principal-agent problem occurs when a principal creates an environment in which an agent's incentives don't align with those of the principle. Generally, the onus is on the principal to create incentives for the agent to ensure they act as the principal wants.

Now how it can improve our understanding of exchange risk means sharing of risk or risk of one borne by other.

The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. This is an example of moral hazard.

For example, an investment banker may gain a bonus for making high profits. This encourages the banker to take risky investments. If he fails and loses $700m, the losses are absorbed by the bank (or taxpayer) – not by the individual banker. This has led to major banking collapses, such as rogue trader Nick Leeson and Barings Bank (1995).

In short, if agent do anythings risky which can cause problem to principal even principal did not commit the act but all risk would be on principal.