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Chapter 14: Q4. (page 302)

Assume that securitization combined with borrowing and irrational exuberance in Hyperville have driven up the value of asset-backed financial securities at a geometric rate, specifically from \(2 to \)4 to \(8 to \)16 to \(32 to \)64 over a 6-year time period. Over the same period, the value of the assets underlying the securities rose at an arithmetic rate from \(2 to \)3 to \(4 to \)5 to \(6 to \)7. If these patterns hold for decreases as well as for increases, by how much would the value of the financial securities decline if the value of the underlying asset suddenly and unexpectedly fell by $5?

Short Answer

Expert verified

The value of financial security will be $62 if the underlying asset suddenly and unexpectedly falls by $5.

Step by step solution

01

Step 1. The value of financial derivates when the underlying assets fall to $5

The value of the financial securities depends upon the underlying assets since these assets are included in the values of such financial securities. Therefore, if the value of the underlying asset decreases, the value of financial securities also falls by the same amount, other things being equal, and vice versa.

The current value of the underlying assets is $7, and the current value of the financial securities is $64. Now, if there is a decline in the underlying assets鈥� value by $5, the value of the underlying assets would change to $2. Hence, with the consequent value of $2, the value of financial security will also reduce by $2 and decrease from $64 to $62.

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Most popular questions from this chapter

James borrows $300,000 for a home from Bank A. Bank A resells the right to collect on that loan to Bank B. Bank B securitizes that loan with hundreds of others and sells the resulting security to a state pension plan, which at the same time purchases an insurance policy from a company called AIG that will pay off if James and the other people whose mortgages are in the security can鈥檛 pay off their mortgage loans. Suppose that James and all the other people can鈥檛 pay off their mortgages. Which financial entity is legally obligated to suffer the loss?

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