The History of U.S. Government Debt and the Financial Crisis

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Chapter 13:Saving, Investment, and the Financial System
Topic:The History of U.S. Government Debt and the Financial Crisis (page 264 - 266)
What caused the financial crisis of 2008-2009? Discuss.
The financial crisis of 2008-2009 was set off by the end of the rallying prices of the real estate in the united stated, popularly referred to as the bursting of the real estate bubble. Banks and lending organizations provided cheap mortgage interest rates, which enticed many homeowners to take out loans they could not pay.
Outdated laws that were not strictly enforced enabled lenders to be careless with their underwriting, resulting in the inability to establish or guarantee the true value of the securities. Banks started lending irresponsibly to parties that could not repay their mortgages. As the number of subprime mortgage packages increased alarmingly, with a high proportion of defaulting, lending institutions encountered financial problems, resulting in the 2008-2009 global financial crisis.
Most of the borrowers who obtained subprime mortgages later defaulted. This led to significant fiscal losses in the banking sector. After a few months, the defaulters started losing their homes through foreclosures. The impact of this bubble bursting started spreading, and the stock market was plummeting within no time. The effect spread to other financial hubs in Europe and Asia, and large corporations such as the Lehmann Brothers collapsed. Others such as the AIG counted millions of dollars in losses. Trust in the financial system eroded, and credit availability deteriorated, resulting in fewer and more cautious investments, and international commerce slowed to a near halt.
The United States government finally sprang into action and adopted the American Recovery and Reinvestment Act of 2009, which bailed out some of the corporations and stopped the wave of financial destruction.
14.Chapter 14: The Basic Tools of Finance
Review Questions: Nos. 1 thru 7 (page 284)
1 The interest rate is 7 percent. Use the concept of present value to compare $200 to be received in 10 years and $300 to be received in 20 years.
Solution.
We have two options, as we shall summarize in the table below.

Option 1

Option 2

Period

10 years

20 years

Expected Return

$200

$300

The interest rate is 7% for both options.
This task aims to find the present worth amount of a single future sum which will be received after n time at an interest rate of r compounded at the end of every interest period.
From prior knowledge:
Present Value= future Value(1+r)n[where: r = interest rate and n = time in years]:
We shall now calculate the present value for our option one as follows:
From the data: the future value for option 1 will be $200, r = 7%, n = 10 years.
Therefore:
Present Value= 200(1+0.07)10
=$101.67
Let us now proceed to calculate the present value for option 2.
Future value = $300, r = 7%, n =20 years.
Present Value= 300(1+0.07)20
= $77.52
As we have seen, the present value for option 1 is $101.67, and that of option 2 is $77.52.
Should we be prompted to choose one between the two options, it will be advisable to choose option one because it has a higher present value when compared to option 2.
2 What benefit do people get from the market for insurance? What two problems impede the insurance market from working perfectly?
Benefits of the Insurance market
Insurance is a contract reflected in a policy in which a person or organization gets financial protection or payment from an insurance provider in the case of a loss. The insurance firm combines its customers’ risks to make payments to the insured cheaper. Through payment of a small amount known as a premium, the insured gets the guarantee of being reinstated back to their initial financial position prior to an unforeseen event. With insurance, people feel safe to continue with their day-to-day operations knowing that they are covered in the event of a mishappening.
Problems Impeding the Insurance Market
* Asymmetrical information:
The insurance industry is flooded with asymmetrical information, which misleads the insurance companies regarding levels of risk of the insured. Some people or property might be riskier than others, but the insurance company may not know this. The company may charge a lower premium for a high-risk insurance cover because of a lack of information. This may lead to the company making many losses in case of an incident.
* The problem of moral hazards
There is a general feeling that insured persons or businesses tend to act more carelessly because they know that the insurance company will compensate them in case of an event. These people or businesses lack the incentive to secure their property, and as a result, the cost of insurance goes up on the insurance company’s side.
3 What is diversification? Does a stockholder get a greater benefit from diversification when going from 1 stock to 10 stocks or when going from 100 stocks to 120 stocks?
There is always a certain amount of risk involved when trading in the equity market. Therefore, stockholders should always ensure that risk levels in their trades are as low as possible. One of the common ways that investors reduce this risk is through diversification. Diversification can be defined as reducing investment risk by investing in a variety of assets such as stocks. In other words, diversification means avoiding putting all one’s eggs in one basket. The idea behind diversification is that all the stocks are unlikely to perform well or poorly simultaneously. Furthermore, since investors cannot be 100% sure which stocks will perform well, they cushion themselves from losses through diversification. In diversification, investors believe that the positive stocks will outweigh the negative ones, and as such, although the returns will be minimal, the risk of losing money is highly reduced.
It is, however, worth noting that the levels of risk reduction highly depend on the number of stocks already on the stockholder’s portfolio. The higher the number of stocks initially, the lesser effect diversification will have on the portfolio’s risk levels. The reverse is also true. Therefore, in our case scenario above, the risk levels are highly reduced when moving from 1 stock to 10 stocks compared to when moving from 100 tocks to 120 stocks. Although the risk levels are reduced by a specific rate in both cases, in the second scenario, the portfolio already has 100 stocks that are very many compared to 1 in the first scenario. Therefore, the risk levels will be reduced by a higher rate when moving from 1 to 10 stocks in a portfolio compared to when moving from 100 to 120 stocks in a portfolio.
4 Between stocks and government bonds, which type of asset has more risk? Which pays higher average returns?
A stock can be defined as a security that represents the ownership of part of a company. It is sometimes referred to as equity. An owner of a stock is referred to as a stockholder and is entitled to a proportion of the company’s profits and assets in the ratio of their stock ownership. On the other hand, government bonds are debt securities by a government to support its spending and day-to-day running of the government. Bondholders can earn periodic interests referred to as coupon payments. Both stocks and bonds have their levels of risk. We will now analyze the risk associated with each before concluding which carries more risk.
Government bonds come with the risk of government default. In case of a default, the investor may lose part or all their investments. Although this scenario is rare, history has taught us that a government can default on its bond, as was the case with the Argentine government in 2001. In addition, bondholders who...