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?
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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 the investor.
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.
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