Class, I'm sure many of you remember
the Publisher's Clearing House sweepstakes - like me, some of you may even have
been a finalist for the super prize of $10 million. :-) If you did win this
prize, you would not actually receive a check for $10 million. Instead, you
would receive $500,000 per year for 20 years. Imagine that you actually were
the lucky winner. From a purely financial standpoint, would you be willing to
accept $8 million today rather than $500,000 per year for the next 20 years?
Why or why not? What non-financial factors might also be considered?
Read the “Global Economic Crisis” story below. Discuss
the credit default swaps and the effects it had on the financial crisis.
Global Economic Crisis
Insuring with Credit Default Swaps: Let the Buyer Beware!
Recall that a credit default swap (CDS) is like an insurance
policy. The purchaser of the CDS agrees
to make annual payments to a counterparty that agrees to pay if a particular
bond defaults. During the 2000s,
investment banks often would purchase CDS for the mortgage-backed securities
(MBS) they were creating in order to make the securities more attractive to
investors. But how good was this type of
insurance? As it turned out, not very. For example, Lehman Brothers might have
brought a CDS from AIG in order to sell a Lehman-created MBS to an
investor. But when the MBS began
defaulting, neither Lehman nor AIG was capable of making full restitution to
Suppose you owned a portfolio
consisting of $250,000 of U.S. government bonds with a maturity date of 30
years. Would your portfolio be riskless? What if your portfolio consisted of
$250,000 of 30-day Treasury bills? Every 30 days your bills mature, and you
reinvest the principle ($250,000) in a new batch of bills. Assume that you live
on the investment income from your portfolio and that you want to maintain a
constant standard of living. Is your portfolio truly riskless? Can you think of
any asset that would be completely riskless? What security comes closest to
being riskless? Explain.
One paragraph 75 words minimum for each question