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Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. What Have We Covered?. Time Value of Money Discounting future payments to obtain a “present value” What discount rate to use? What if future payments are uncertain?
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Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia
What Have We Covered? • Time Value of Money • Discounting future payments to obtain a “present value” • What discount rate to use? • What if future payments are uncertain? • Mortgages • Self amortizing (means payments include a principle ‘paydown’ as well as interest payments • If you are the lender, your asset is going to zero • ABS (Asset-backed securities) • Create a ‘pool’ of securities • Create new securities • Define what income from the pool goes to which securities
Back to ABS • Imagine a pool of two ‘accrued interest balloon mortgages’ of $ 100,000 each payable in the ‘next’ period. • Create two securities: • Each ‘nominally’ receives $ 100,000 • Security A: gets paid so long as ‘both’ mortgages don’t fail • Security B: only gets paid if both neither mortgage fails • Assume 10 percent chance of failure for either mortgage • What is the chance of failure for Security A? – Security B • Ratings and pricing (in the past) were based solely on ‘probability of default’? • One answer: 1/10 times 1/10 = 1/100 . So A has 1 % probability of default • 1/10 plus 1/10 minus 1/100 = 19/100 So B has 18% probability of default • But that answer assumes ‘independence’
