Lecture 16

# Lecture 16 - 11/2/10 Chapter 12: Economics of Information...

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11/2/10 1 Lecture 16 The Economics of Information and the Financial Crisis Chapter 12: Economics of Information F. Resolving asymmetric information with costly signaling G. Insurance markets H. Economics of information and the financial crisis key development of last 10 years-- changes in how risky loans became financed Consider risky loan Expected value = (0.8)(150) + (0.2)(0) = 120 Expected return = (120 - 100)/100 = 20% lend 100 prob 0.8 prob 0.2 150 0 Consider pooling risky loans lend 100 0.8 0.2 150 0 lend 100 0.8 0.2 150 0 lend 200 0.64 300 0 150 If loans are independent, probability both pay off is (0.8)(0.8) = 0.64 Consider pooling risky loans lend 100 0.8 0.2 150 0 lend 200 0.64 0.04 300 0 lend 100 0.8 0.2 150 0 150 If loans are independent, probability both default is (0.2)(0.2) = 0.04 Consider pooling risky loans lend 100 0.8 0.2 150 0 lend 200 0.64 0.04 300 0 lend 100 0.8 0.2 150 0 150 If loans are independent, probability exactly one defaults is 2(0.8)(0.2) = 0.32 0.32

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11/2/10 2 Could split the pool into new assets with very different risk characteristics 300 150 0 0 10 0 180 20 0 120 120 0 0.64 0.32 0.04 lend 200 senior tranche junior tranche keep for me 300 150 0 0 10 0 180 20 0 120 120 0 0.64 0.32 0.04 lend 200 senior tranche junior tranche keep for me senior tranche sold to investor for 100 pays 120 with probability 0.64 + 0.32 = 0.96 pays 0 with probability 0.04 expected value = (0.96)(120) = 115.2 expected return = 15.2% less expected return, but safer 300 150 0 0 10 0 180 20 0 120 120 0 0.64 0.32 0.04 lend 200 senior tranche junior tranche keep for me junior tranche sold to another investor for 100 expected value = (0.64)(180) + (0.32)(20) =121.6 expected return = 21.6% higher expected return, but riskier
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## Lecture 16 - 11/2/10 Chapter 12: Economics of Information...

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