ECON319 Flashcards
What model would you use to explain why a risk averse home buyer would purchase a subprime mortgage, and why is it applicable?
Rish aversion: Concave utility.
Applicable because the terms might seem like a safe way to enter the housing market at low costs.
People also lacked the financial literacy to be able to judge the quality of the mortgage, and people didn’t really know what they were buying.
What model would you use to illustrate and explain why a risk averse buyer would purchase a home in the middle of the real estate bubble?
Model: Asset bubble experiment
Applicable because it shows how a bubble can happen, and these implications also show why someone wants to join the bubble. A risk averse buyer wants to join in because there was a perception that it was the safest investment to make
What are the assumptions of the asset bubble experiment? 7
- Players start with $225 to trade.
- There are several trading rounds
- After each round the assets pay a dividend
- Participants receive information about the assets’ supposed value.
- At the end, the assets will be redeemed for 14$
- Trades are possible if the asks are below the bids
- The market clears.
What are the phases of the asset bubble experiment?
- In the start, the trading is based on the true value - See stable prices
- Bubble formation: Positive news and herd behavior or speculation drive prices above fundamental values
- Peak: Bubbel reaches a peak and prices are unsustainable
What model would you use to illustrate and explain how a CDO, which is a securitization of B and C tranches of MBS’s, make economic sense but also contributed to the great recession? How?
Model: Portfolio theory
Show the graph and that the tranches are not on the optimal line.
Show that by diversifying, i.e. pooling the tranches together you could get a lower variance.
Not necessarily true because the covariance is a lot higher then what was thought in the crisis.
How can you show with portfolio theory that diversifying reduces risk?
Consider a portfolio of two assets: A and B, both with their own return and variance (Risk).
Total return and risk of the portfolio depends on the proportion of each asset in the portfolio.
* E(Rp)=WaE(Ra)+WbE(Rb)
* Var(Rp)=Wa^2Var(Ra)+Wb^2Var(Rb)+2WaWbCov(Ra,Rb)
* The last term shows the impact of diversification, if the covariance is lower than the variance of both, the variance of the portfolio as a whole will be lower than the variance of individual assets.
What is quantitative easing and how is it equivalent to monetary policy?
Quantitative Easing is a policy tool used when interest rates near zero and the central bank needs to lower the interest rates, so they purchase bonds and long term assets to increase money supply.
This will shift money supply outwards and is therefore equivalent to monetary policy. (In a graph with interest rates on y and money amount on x) Ms straight line upwards Md falling
Explain how a long period of monetary easing could have created conditions for the great recession.
Models:
* Monetary policy - Low interest rates increases borrowing
* Disorting balance between savings and investment
Explain how credit default swaps create moral hazard
Model: Moral hazard and insurance
Insurance creates moral hazard because being careful is more ‘costly’ than what it is being careless, and having insurance means you are indifferent between one outcome or the other.
What are the assumtions of the insurance game (Moral Hazard) and the order of play?
Players:
* Risk averse buyer
* 2 insurance companies (No profits)
Order of play:
* Insurance companies offer contract (x,y) - (x = x = premium, y = payoff)
* Buyer chooses a contract
* Buyer chooses a behavior - Careful of careless (Unobservable to insurer)
* Nature chooses whether there is an accident or not with probability 1/2 if careful and 3/4 if carelsess
* Being careful costs buyer a small amount ‘Epsilon’
What are the equations in the insurance game (Moral Hazard)? How does the graphs look?
Utility:
a. Careful
i. U(buyer)=1/2U(12-x)+1/2U(12-12+y-x)
ii. U(Insurer)=1/2U(x)+1/2U(x-y)
b. Careless
i. U(buyer)=1/4U(12-x)+3/4U(12-12+y-x)
ii. U(Insurer)=1/4U(x)+3/4U(x-y)
- Wealth with theft on Y axis and no theft on x axis
- Profit line of insurer going from (0,12) to (12,0)
- Full insurance is a 45 degree outward
- Equilibrium in the crossing.
What model would you use to illustrate how a failure of a MMF containing CPs of an investment bank nearly shut down these markets? How is the model applicable?
Model: Bank run game
It illustrates the rational behavior of depositors in running the bank. It also shows the nature of banking in turning short term deposits into long term investments.
What are the assumtions for the bank run game?
- Four depositers ($1000 dollars each)
- Banks offer contracts contingent on withdrawal time
- Three periods: Yesterday, today, tomorro
- Depositors deposits yesterday, without knowing their preference towards withdrawal time
- Two preferences: impatient and patient (Equally likely)
- Two investments: Short (R=1) and long term(Illiquid investment - R>1 tomorrow, L<1 today)
Why did monetary policy contribute to inflation post-covid but not post great recession?
Great recession
* Underutilized capacity
* Confidence was low
* Banking sector was more cautious due to tighter regulations and a need to repair their balace sheets
Covid
* There was a shut off in supply, not demand and restrictions on demand by the governments. (Aggregate supply shifts in)
* Meeting this with monetary policy shifts aggregate demand out.
* Post lockdown, people had saved up because they didn’t have anything to spend money on
What model would you use to show that masks and vaccine mandates where necessary? Why?
Model: Public goods
Because if not the spread would have been exponential.
