Chapter 2: Q.4 (page 96)
If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?
It will be beneficial to have bonds rather than equities.
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One of the factors contributing to the financial crisis of 2007–2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection
Suppose you have just inherited \(10,400 and are considering the following options for investing the money to maximize your return:
Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account against bank failure.
Option 2: Invest the money in a corporate bond with a stated return of 6%, although there is a 10% chance the company could go bankrupt.
Option 3: Loan the money to one of your friend’s roommates, Ayesha, at an agreed-upon interest rate of 7%, but you believe there is a 7% chance that she will leave town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.)
b. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend \)50 to find out extra information about Ayesha that would indicate with certainty whether she will leave town without paying, would you pay the $50? What does this say about the value of better information regarding risk?
How do conflicts of interest make the asymmetric information problem worse?
Suppose a few investors are looking for an investment opportunity that will yield high returns. They are willing to invest in private securities instead of government bonds. However, their analyst found that currently most companies listed on the market and are actively trading in securities are in trouble, which would make them risky investments. What can you conclude from this situation? How would you advise the investors?
Go to the St. Louis Federal Reserve FRED database, and find data on federal debt held by the Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international and foreign investors (FDHBFIN). Using these series, calculate the total amount held and the percentage held in each of the three categories for the most recent quarter available. Repeat for the first quarter of 2000, and compare the results.
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