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Chapter 2: Q.9 (page 97)

A significant number of European banks held large amounts of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

Short Answer

Expert verified

The cost of holding such securities is an adverse shift in the market scenario, as a significant drop in the US stock market results in a high default risk and cases, which leads to an increase in mortgage prices.

Step by step solution

01

Step 1. Introduction

As the name suggests, the securities backed by mortgages are known as mortgage-backed securities or MBS. It is an investment that is created by a bundle of mortgages. These mortgages are sold by banks which issued them.

02

Step 2. Explanation

When European banks have huge amounts of assets in the form of mortgage-backed securities, they are able to provide financial and capital support to people in the US financial market through the exchange of these securities. It permits both parties, such as European banks and US borrowers, to benefit from it.

The cost of internationalization is that the decline in the value of mortgage-backed securities caused a financial crisis in the European market. So, even though housing market collapse happened in the US, its affect was felt in Europe.

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Most popular questions from this chapter

If you are an employer, what kinds of moral hazard problems might you worry about with regard to your employees?

If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard problem still exist?

Give at least three examples of a situation in which financial markets allow consumers to better time their purchases.

How does risk sharing benefit both financial intermediaries and private investors?

Suppose you have just inherited \(10,400 and are considering the following options for investing the money to maximize your return:

Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account against bank failure.

Option 2: Invest the money in a corporate bond with a stated return of 6%, although there is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friend’s roommates, Ayesha, at an agreed-upon interest rate of 7%, but you believe there is a 7% chance that she will leave town without repaying you.

Option 4: Hold the money in cash and earn zero return.

a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.)

b. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend \)50 to find out extra information about Ayesha that would indicate with certainty whether she will leave town without paying, would you pay the $50? What does this say about the value of better information regarding risk?
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