Week 7-Personal finance

Question 1

what is the life-cycle model of saving?

Answer 1

• Economists used to think that people’s consumption and savings decisions in one period were based on the current
income for that period
• A different approach is to think that consumption and savings decisions take into account lifetime economic circumstances, before and after the current period (Franco Modigliani, Milton Friedman)

• The concept of time value of money provides
a way to price future consumption, savings,
and, in general, moving the value of resources across time

– Borrow for a house: consumption brought
forwards
– Save for retirement: consumption postponed

Provided financial instruments (loans and pension
funds) are available

Question 2

What is human capital?

Answer 2

The present value of one’s future labour

income.

Question 3

What is permanent income?

Answer 3

The constant level of (real) consumption
spending that has a present value equal to
one’s human capital

Question 4

Is education an investment in human capital?

Answer 4

• From an economics/finance perspective,
the financial benefit of education is viewed
as an investment in human capital

Question 5

Is a post-graduate degree a good investment?

Answer 5

• The financial side of the decision shows that benefits outweigh costs, based on your estimates of a number of variables.

Question 6

What are income contingent loans?

Answer 6

The Income Contingent Repayment (ICR) plan is designed to make repaying education loans easier for students who intend to pursue jobs with lower salaries, such as careers in public service. It does this by pegging the monthly payments to the borrower’s income, family size, and total amount borrowed

Question 7

What is a pure discount loan?

give an example

Answer 7

Loans for which both interests and principal (amount borrowed) are repaid at maturity (end of the contract). Normally short maturity, maximum one year

An example:
zero‐coupon bonds issued by governments

Question 8

What are interest only loans?

Answer 8

Loans for which interests are repaid overtime,
and the entire principal (amount borrowed) is
returned at maturity (end of the contract)

Question 9

What are amortised loans?

Give an example

Answer 9

Loans for which both capital and interests are
paid regularly throughout the life of the loan, period by period until maturity.

An example: most mortgages

Question 10

What are mortgage risks?

Answer 10

• One of the risk inherent in a mortgage has to do with house prices. In the example above, if house prices were to fall below the value of Ms June’s mortgage, she would end up with negative equity (the asset is worth less than the loan). If she needs to sell the house, she incurs a loss
• Another risk has to do with changes in the mortgage interest rates which could be variable rates instead of fixed, as in the example above. In this case they often depend on LIBOR (London Interbank Offered Rate), a benchmark rate at which banks lend to each other