Lectures 16-22

Question 1

capital income tax

Answer 1

taxes on the income you make from your investments (i.e. stocks)

Question 2

Capital Income Tax System

how is interest taxed? Is this the same when interest is paid by the state and local governments (municipal bonds?)

how are dividends taxed?

Answer 2

interest is taxable at ordinary income tax rate (progressive)

when it’s paid in the form of municipal bonds (by the government), the interest you earn is tax-exempt

dividends are taxed at a lower progressive rate than interest

Question 3

capital gains

Answer 3

profit for when you sell the asset for a higher price than you bought it

Question 4

taxes for short-term capital gains vs. long-term capital gains

Answer 4

short term capital gains (ordinary income tax rate)

long term capital gains (dividend tax rate)

Question 5

what happens if you hold on to your capital gains until you die?

Answer 5

the price of the capital gains is reset and the asset can then be passed on to your heirs

disincentivizes you to sell so you don’t have to pay taxes on it and you can just give it to your heirs

Question 6

when are capital gains taxed?

Answer 6

when they are REALIZED (when the asset is sold)

vs. dividends are taxed when they are paid

therefore, even though the tax rate for long term capital gains and dividends are the same, it’s advantageous to convert dividends into capital gains

Question 7

calculating the real interest rate without taxation

Answer 7

real interest rate = nominal interest rate - inflation

Question 8

after-tax real interest rate

when is capital income taxation much higher?

Answer 8

when inflation is high, the discouraging effect of capital income taxation is much stronger

when inflation is higher, after-tax interest rate is much lower (even negative)

Question 9

IRA

Answer 9

tax-favored individual retirement accounts

set up by individuals with low contribution amounts

Question 10

401(k)

Answer 10

managed by private-sector employers

• higher contribution limits
• employers decide employee investment choices
• employers can make matching contributions to the plan

Question 11

traditional IRA/401(k) vs. Roth IRA/401(k)

Answer 11

traditional: you don’t pay a tax when you put the money into the account, but you have to pay taxes when you take the money out

roth: pay taxes now on contributions, but no taxes later on withdrawals

and in both scenarios, the interest that you earn on the returns throughout the year is not taxed

Question 12

which is better: Roth or traditional?

Answer 12

if you expect taxes to be higher in the future, do Roth over traditional

if you expect to be richer in the future (and thus expect to pay a higher marginal tax rate), do Roth over traditional

Question 13

withdrawal rules for a traditional account

Answer 13

withdraw free of penalty after age 59.5
you must start to make withdrawals (required minimum distributions) after 72

if you want to withdraw money before, you pay a penalty

always pay Federal and state income tax on your withdrawals

Question 14

withdrawal rules for a Roth account

Answer 14

you can always withdraw money without penalty (since you already paid taxes)

withdraw capital income earned in the account free of penalties after 59.5, if you account is at least 5 years odld

Question 15

changes in asset allocations for 401(k)

Answer 15

less company stock (concentrates risk exposure), less money market funds (too low of a return to finance retirement)

more balanced funds which come in the form of target date funds

Question 16

balanced funds

Answer 16

both stocks and bonds

Question 17

target date funds

Answer 17

start out with more equity (stocks) and shift into bonds as your retirement date approaches

Question 18

target date fund glide path

Answer 18

equity share starts out high and diminishes gradually to some much lower level in retirement

Question 19

why do people suggest to invest more aggressively when you are young and cut back risks when you get older? (time diversification and human capital argument)

Answer 19

young people have high potential of human capital (future earning power- relatively safe asset)

when young, large implicit investment in safe assets (earning power) so you should compensate by having some extra risk in your financial portfolio (stocks/equities)

as you get older, your future earning power decreases and your financial savings increase

so when you’re older, with a smaller implicit investment in safe assets (less earning power) and larger financial portfolio, cut back financial risk as retirement approaches.

younger people can tolerate more risk (bc they have more time to recover from losses) but less money to invest … since they have a larger time horizon and they are expected to earn more money in the future, the risk of an asset stabilizes over long periods of time so it makes sense to be risker earlier on it life (time diversification)

older people have more money to invest, but less time to recover losses so they should be more conservative

Question 20

time diversification

Answer 20

risk you take with equity investing is less If you spread the dollar investment out over a period of time rather than concentrating it all in a single period

diversifying the dollars you put in the stock market over time

“half stocks all the time” is safer than “all stocks half the time”

Question 21

limitations of tdf’s (target date funds)

Answer 21

tdf only adjust equity share to your age, but if you have more savings relative to your income, you should cut back on your equity share

some TDF’s are actively managed, inadequately diversified, and charge inappropriately high fees

Question 22

insurance manages which risks of life? (PPL)

Answer 22

personal (death, illness, disability)
property (fire, flood, theft)
liability (risks to others for which you are responsible)

Question 23

property and causality insurance (P & C)

Answer 23

homeowners, renters, auto insurance

Question 24

moral hazard

Answer 24

the probability or cost of a loss, once you are insured, will go up

(probability) since you know you’re insured, you’re going to be more careless about the way that you behave

(cost)
if you know you’re insured, you let insurance company pay for repair, as opposed to trying to find a cheap repair

lack of inventive to guard against risk when one is protecting from its consequences

Question 25

deductible

Answer 25

the amount you're responsible for paying if a loss/repair is needed incentivizes you to be careful and doesn't allow you to claim for minor losses

Question 26

premiums

Answer 26

how much you pay to have insurance future insurance costs, if you make a claim, your premium will rise

Question 27

cost of property and causality insurance depends on

Answer 27

value of property location of property risk rating of owner security devices you install deductible coverage limit

Question 28

coverage limit

Answer 28

the maximum amount of insurance a company will pay

Question 29

low deductibles: money wasted summary of article

Answer 29

on average, you can save more money from having a higher deductible than having a lower deductible people are extremely risk averse and are paying extra (close to $100) in premiums to only be protected an extra $20 bucks

Question 30

do lower deductibles have higher or lower premiums and why?

Answer 30

low deductibles have HIGHER insurance premiums 1. if companies have to process more small claims, operating costs of company increases 2. moral hazard: if people are less exposed to losses, more likely to file claims/get into trouble, raising cost of insurance

Question 31

why do people like low deductibles?

Answer 31

typically for people who lack emergency funds if you find it difficult to save, this insurance serves as a commitment device when losses occur but they're expensive and a better alternative is to combine high-deductible policy with an emergency savings fund

Question 32

do those who have been insured longer get more sophisticated and change their deductibles from lower to higher?

Answer 32

no! low deductibles used to be cheaper, but as home values rose, difference in premiums also rose renewal contracts do not list this new menu?

Question 33

insurance companies cover ____ losses

Answer 33

unknown losses

Question 34

preexisting conditions

Answer 34

known losses, won't be covered by unregulated private insurers medical history of a serious problem before 2012, large group poliicies covered preexisting conditions, but individual and small group policies either excluded or charged high prices for coverage after affordable care act, it was forbidden to exclude or charge more for preexisting conditions

Question 35

continuation coverage

Answer 35

you're still given healthcare insurance for 18-36 months if you lose access to a group policy due to job loss, divorce or death from employee

Question 36

medicare v medicaid

Answer 36

medicare - for people over 65 (federal) medicaid - for lower income people (state-administered) - think AID, financial AID, poor

Question 37

two main challenges to u.s heatlh care system

Answer 37

1. preexisting conditions 2. health care costs (companies try to cut cost by having a select list of providers, having high deductibles etc)

Question 38

basic v major medical health insurance

Answer 38

hospital, surgical, and physical health expenses major: anything beyond that

Question 39

long term care insurance

Answer 39

worth considering if you are over 60 and lack family care options

Question 40

marginal utility of wealth

Answer 40

high when wealth is low low when wealth is high diminishing marginal utility think ec10 (100 to someone who makes 1,000 is much more than 100 to someone who makes 10,000)

Question 41

actuarially fair price

Answer 41

the premium rate must equal the probability of an accident would be possible if losses were idiosyncratic ( uncorrelated across individuals) and insurance company has no sales or operational costs

Question 42

full coverage

Answer 42

loss has no effect on your marginal utility full replacement of lost income, full coverage of medical costs,

Question 43

partial coverage

Answer 43

insures only part of a loss leaving marginal utility of the loss slightly greater than the marginal utility of the premium (base conditions

Question 44

why is insurance not actuarially fair?

Answer 44

sales and operating costs costs of fraud prevention moral hazard (need to have some exposure to loss so that they can have an incentive to be careful) adverse selection: makes insurance expensive for all but the riskiest people

Question 45

adverse selection (in insurance)

Answer 45

people have different loss probabilities, and they know their own loss probability (asymmetric information) insurance company either does not know loss probability or is prevented by regulation to adjust cost of insurance to reflect that - i.e. Affordable Care Act- companies couldn't charge extra for people with preexisting conditions (aka higher loss probabilities)

Question 46

in adverse selection, who demands more insurance? high-risk people or low risk-people? how does this impact the cost of insurance?

Answer 46

high-risk people demand more insurance than low risk people Lowers profits (high-risk people are more likely to file claims than low-risk people) which forces companies to drive up the price of their insurance since the cost is so high, only the highest risk people will choose to buy insurance

Question 47

death spiral

Answer 47

only the highest risk people will buy insurance more people are dropping their coverage (particularly healthy people)

Question 48

how affordable care act is trying to fight death spiral

Answer 48

a mandate to buy health insurance, with a penalty if you did not tax credits to cover health insurance costs for low-income people (higher than medicaid but still low) distilling accessible information and healthcare shopping

Question 49

life insurance

Answer 49

offset losses caused by your death to the people who care about you losses include -funeral cost - lost income

Question 50

term life insurance

Answer 50

in force for a specified period if you die within the term, you get a specified death benefit (face value of insurance policy) you get nothing if you're still alive at the end of the term

Question 51

do life insurance premiums rise or fall over time?

Answer 51

they rise!!! as you get older, the more likely you are to die, which means the more likely that insurance companies are going to have to pay out and give you the death benefit as you get older, risk to insurance companies increases

Question 52

whole life insurance

Answer 52

forced indefinitely if you keep paying premium, insurance pays death benefit if you stop paying, you get specified cash value

Question 53

variable v universal (whole life insurance )

Answer 53

variable: gives you low minimum death benefit and cash value, but if risky investments do well, you get more return universal: low minimum required to get death benefit, but if you pay higher premiums you can raise cash value of benefit

Question 54

lapsing (insurance)

Answer 54

when people take out policies and then fail to make their premium payments companies profit when people lapse after a period of paying premiums, because they get all the premium money and then they don't have to pay out the death benefit

Question 55

is lapsing common?

Answer 55

yes! lapse rate falls as people stay will policy, but it still exists <- lapse rate is higher in first year of policy than 5th year of policy smaller policies are more likely to lapse! (smaller policies are likely bought by people with more volatile incomes, which means they just aren't able to pay premiums as consistently)

Question 56

do people anticipate lapsing?

Answer 56

no! people are naive about their future behavior

Question 57

why do people lapse?

Answer 57

income decreased, people forgot to make payments,

Question 58

which life insurance is best to buy?

Answer 58

if you don't think you'll lapse, buy long term life insurance if you think you will lapse, buy short term life insurance and scale back coverage later in life when premiums rise ad dependents are less likely to be vulernable

Question 59

pricing between term and whole life insurance

Answer 59

short term life insurance (fairly priced- lower premiums when you're young, higher as you get older) long term life insurance or whole life insurance are typically more expensive in the early years and cheaper later (premium is high (fixed) but mortality risk increase with age)

Question 60

annuities

Answer 60

while life insurance protects you from dying too soon, annuities protect you from living too long

Question 61

immediate annuities

Answer 61

pays a stream of income for your lifetime, starting now

Question 62

deffered annutiies

Answer 62

pays a stream of income for your life time, starting n years from now

Question 63

is the interest rate paid by annuities higher or lower than the yield on an ordinary bond?

Answer 63

higher! bc you may die early and never receive later payments, esp if you die before a deffered annuity plan

Question 64

fixed annuity

Answer 64

makes fixed payments in nominal or real terms

Question 65

variable annuity

Answer 65

makes payments that reflect the performance of the stock market

Question 66

why is there a low demand for annuities

Answer 66

almost everyone has form of annuity in social security or defined benefit pension funds private annuities are expensive because of adverse selection people want to leave money for their children

Question 67

estate planning

Answer 67

having a will

Question 68

advanced directives (healthcare proxy and living will)

Answer 68

guide to healthcare if you turn into vegetable living will - what you want to happen healthcare proxy- gives power of attorney to someone to guide your healthcare decisions

Question 69

prenuptial agreement

Answer 69

minimize impact of divorce

Question 70

financial advisors and "one size fits all"

Answer 70

not getting customized advice doing the same as target date funds by charging higher fees

Question 71

what is the issue with investing only in company stock?

Answer 71

undiversifying your financial portfolio

Question 72

do advisers steer their clients toward low cost-index funds?

Answer 72

no! steer them towards higher-fee strategies not just because of alterior motives but also because of their own ignorance....they behave similarly with their own finances

Question 73

how did financial advisers respond to these strategies (chasing returns, company stock, index funds)?

Answer 73

advisers recommend more strongly against index funds than chasing returns or owning company stock from most supported to least supportive chasing returns, company stock, index funds

Question 74

fiduciary standard

Answer 74

legal obligation to act in the best interest of your client

Question 75

suitability

Answer 75

less strict than fiduciary just saying that you shouldn't act crazy with someone's finance, but still not held to the same standard

Question 76

which financial advisers meet the fiduciary standard? (3 options)

Answer 76

CFP - certified financial planners RIA- registered investment advisors all advisers for retirement accounts

Question 77

fee-only advisor

Answer 77

do not receive any income from commissions!! stronger than fee-based, which allows for some commissions

Question 78

robo-advisors

Answer 78

online interfaces for financial advice

Question 79

structured products

Answer 79

offer a high headline rate (high interest rate) but the fees are high and incredibly complex essentially deliver high return by investing in risky assets, with little downside protection they gotten more complex over time

Question 80

tricks associated with structured products (and how companies don't always get their pay in extra fees)

Answer 80

1. and even if you get your money back, you're losing money as compared to just investing in a safe investment you're getting a 0% return, which is lower than just putting money in a money market or bond 2. get the price return on a stock index, but you're not getting the dividend yield, which companies end up taking sometimes the safe investment and dividend yield is v low....meaning that companies can't always eat up those fees as much as they want 3. generate income by selling out-?????

Question 81

speculators

Answer 81

buy asset because you hope you'll be able to sell for a higher price in the future

Question 82

speculative assets

Answer 82

things that are easy to trade, but hard to assess the fundamental value assets that offer a non-financial conveinence yield (i.e art, gold, jewelry) assets in fixed supply with limited subsistuties, so demand shocks affect price and not quantities

Question 83

speculative bubbles

Answer 83

A speculative bubble is a spike in asset values within a particular industry, commodity, or asset class to unsubstantiated levels, fueled by irrational speculative activity that is not supported by the fundamentals. asset prices excel upwards, and then suddenly crash driven by naive speculators who are chasing returns

Question 84

fast v slow bubbles

Answer 84

if a bubble is driven by expectations of very high returns, it's going to burst quicker because it can't be sustained as long if a bubble has lower expected returns, going to live for longer bubbles are slower (and longer) for environments with low interest rates a rise in interest rates, will make a bubble faster (and shorter)

Question 85

bank run

Answer 85

when a large number of a bank's customers hurry to withdraw their deposits simultaneously because they believe the bank may fail. a deposit in an unregulated bank is a speculative asset so people believe that their money is safe if not everybody withdraws their money at the same time... if people think the bank may fail, they are quick to take out their money

Question 86

stablecoin

Answer 86

cryptocurrency with a stable USD value but they run like unregulated banks

Question 87

ponzi schemes

Answer 87

disguise cash from speculators as fundamental cash flows a form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.

Question 88

pump-and-dump schemes (three phases)

Answer 88

1. get position in an illiquid asset (cannot be easily converted into cash for their fair market value) (Penny stock) 2. attract naive investors with rumors of good news 3. sell out to naive investors at an inflated price In a pump and dump scheme, fraudsters typically spread false or misleading information to create a buying frenzy that will “pump” up the price of a stock and then “dump” shares of the stock by selling their own shares at the inflated price.

Question 89

meme stock

Answer 89

any stock that, for some reason or another, has gained a frenzied following of retail investors, often due to its status as an "underdog" in the market.

Question 90

fintech

Answer 90

financial technology

Question 91

peer-to-peer lending

Answer 91

allows people to lend or borrow money from one another without going through a bank.

Question 92

distributed ledgers

Answer 92

using blockchain technology transactions are recorded and verified by a network of computers as opposed to a single database

Question 93

decentralized finance (de-fi)

Answer 93

everything from simple transfers to complex financial functions are facilitated without any third-party involvement. why? - central databases have monopoly power <- higher prices, lower incentive to innovare - lack of trust in financial institutions

Question 94

smart contracts

Answer 94

contracts that can execute themselves without the need for financial intermediaries

Question 95

non-fungible tokens (NFT)

Answer 95

unique Digital object that can replace membership cards and id's

Question 96

blockchain

Answer 96

transactions that are recorded and cryptographically linked altering any one block will change the entire chain

Question 97

proof of work (POW) system

Answer 97

Proof-of-work (PoW) is a blockchain consensus mechanism that incentivizes network validation by rewarding miners for adding computational power and difficulty to the network problems - transactions are expensive - energy/electricity consuming

Question 98

proof of stake (POS) system

Answer 98

It is a way to decide which user or users validate new blocks of transactions and earn a reward for doing so correctly. allocating voters

Question 99

some problems of cryptocurrency

Answer 99

transactions are expensive and slow many have unstable USD so aren't good for saving diret ownersjip requires a private key, if you lose that you're fucked crypto exchanges are suspectible to fraud

Question 100

oracles

Answer 100

systems that import data from the real world to the blockchain vulnerable to hacking

Question 101

disclosures

Answer 101

providing information at a time that a financial decision has to be made

Question 102

nudges

Answer 102

making certain decisions slightly easier by establishing defaults

Question 103

disclosure empire

Answer 103

terms of credit, informed consent in healthcare, often complex and ignored

Question 104

leakage

Answer 104

side effects/behavior that can offset the apparent gains from a disclosure or nudge (borrowing more on second card to pay first card faster)

Question 105

CARD act experiment

Answer 105

when people were given information about paying off their debt in 3 years, they were more likely to do it rather than just paying the monthly minimum

Question 106

designing better disclosures (3 ways)

Answer 106

1. simplify 2. standardize (make comparisons easy) 3. exploit social compettiveness 4. Personalize info 5. make it vivid

Question 107

nudges in retirement saving and effects on contribution rate

Answer 107

automatic enrollment increases participation many people participate with the default Savings rate (3% or 6%) but too high of a savings rate can lead people to drop out and discourage people from saving more than the high default rate

Question 108

Nudges that Fail (2 reasons)

Answer 108

1. people actually have strong preferences - women change their legal name even though that's not the default 2. there may be a counternudger - self-interested party that's trying to undo the effect of the nudge

Question 109

Responses to Nudge Failures

Answer 109

1. give up and accept that people know what they want 2. improve choice architecture (design of the nudge) 3. restrict counter nudges

Question 110

consumer financial protection

Answer 110

trying to regulate markers ensures that markets for consumer financial products are fair, transparent, and competitive. Consumer Financial Protection Bureau (CFPB) - can't pay more than the amount on prepaid cards - rules on payday lending

Question 111

a case is made for regulation when

Answer 111

externalities asymmetric information public goods market power

Question 112

externality

Answer 112

where one agent's actions affect another in a way that cannot be charged for i.e. air pollution (negative externality) if negative, externality can be regulated with taxes and regulations if positive, externality can be regulated with subsidies

Question 113

asymmetric information

Answer 113

when some people in the market know more about their circumstances and behaviors than others (selling a used car or buying health insurance)

Question 114

market power

Answer 114

have a monopoly high prices, underprovidision, and lack of innovation in consumer financial markets, providers may have market power because consumers are too reluctant to search

Question 115

public goods

Answer 115

can be enjoyed by all, but cannot be limited to those who paid for them i.e Clean air or information (disclosure regulation)

Question 116

paternalistic

Answer 116

that a consumer regulator knows what's better for consumers than the consumers themselves

Question 117

if you Care about the welfare of poor people, would you be more or less paternalistic?

Answer 117

more! because behavioral agents are on average poorer than rational agents

Question 118

Sharpe ratio

Answer 118

measures how well a stock is doing relative to a risk-free return return of stock -risk-free return / sd of stock measuring the performance of an investment relative to its risk

Question 119

leverage

Answer 119

when you borrow money to buy an asset leverage = value of the asset/ amount of your own money you invest