1) In 1994 the Bulgarian government issued bonds on which the coupon payments were tied to the GDP of the country. I’m simplifying here, but basically a low level of GDP (a country-level measure of economic growth and activity) would reduce the interest payments on the bonds, and a high level of GDP would increase the interest payments.
· Suppose a US investor buys these bonds, what risks is the investor exposed to? (list everything which could negatively affect the investment!)
One of the risks associated with this bond is Interest rate risk. The prices of bonds are inversely related to rates of interest. A higher GDP of Bulgaria would mean that the price of the bond will decrease, however a lower GDP would mean that the price of the bond will decrease. The interest rate on a bond is set at the time it is issued, which is in 1994. The coupon in 1994 reflected the interest rate at the time of issuance, however the increase in interest, in GDP, will make people unwilling to purchase bonds. In other words, the US investor will have a difficulty reselling the bond to secondary markets should the GDP of Bulgaria increase. Should he decide to keep the bonds, then his interest income is very much dependent on the GDP of the nation. There are is no fixed amount that he can count on.
Another risk associated with bond is credit risk. Just as individuals default on mortgage payments, bond issuers can possibly default as well. Usually, bonds issued by the government are immune from this risk, but nothing is risk free in issues such as credit.
Call risk is another risk the investor is exposed to. The government of Bulgaria can easily call back the bonds before maturity so they can issue it at a lower interest rate forcing the investor to reinvest the principal at a lower interest rate.
Inflation risk is perhaps the worst of the investor must endure. The GDP of Bulgaria will suffer immensely if significant inflation is suffered by the country. Anything that affects the GDP of the nation will affect the interest rates of the bonds issued.
· Are their any ways to manage/offset some of these risks?
Credit risk, generally associated with any kind of credit is practically managed in investing in these bonds. Governments, generally pay out their bonds, and on time too because it will not look good for the government to default from its loans to its people or its investors. The other kinds of risks are hard to manage given that they are dictated by a nation’s GDP. The investor from the US cannot likely influence how Bulgaria’s GDP shall fluctuate.
2) In the 1970’s Yale University implemented a system for students in which the students would receive loans to pay their tuition. Repayment of the loans involved the following arrangement:
-after graduation all students enrolled in the program would pay 0.4% of their annual income per $1,000 borrowed until the entire cohort, or class, had paid off their debt, or until 35 years had passed, whichever came sooner. (See “The New Financial Order” by Robert Shiller, 2004, Princeton University Press, page 143)
· What risks are the students exposed to?
The students, are exposed to the risk of paying more than they owe given that the program ensured that they can finish their studies but they essentially had to pay for royalties for 35 years. Imagine a student in 1974 who borrowed $30,000 to finance his Yale education. Assuming he has graduated in 1978, and started to earn $100,000 annual. For this first year alone, he will have to pay Yale .8% of his annual income which is $800. This payment will not stop until each person in his class, who obtained a loan from the University, has paid off his debt. The percentage of payment is fixed but the salary of this Yale grad keeps increasing yearly. Suppose this student managed to pay off his loan in 20 years, yet there are 5 people from his class who have not yet paid theirs, possibly because these 5 people have no income, then for fifteen more years the person is indebted to Yale for .8% of his annual income that is probably in the million dollar bracket by now.
· What risks are the lenders of money exposed to?
Yale, on the other hand is exposed to the risk of students paying off their loans quickly. Given that Yale produces quality graduates (i.e. President Bill Clinton), the students can easily pay back their indebtedness given their instant financial status after graduation. The time value of money is the greatest exposure of Yale. A $30,000 loan the University has given in 1974 has bigger value as compared to the $30,000 the students gave back in installment payments. The entire class might a find a way to fully pay their debts and Yale may not recover any interests for the loan extended.
· Are their any ways to manage/offset some of these risks?
If one student, or a group of students has/have the means, then he or they can just buy off the remaining loan of their classmates, to ensure that everyone is debt free from Yale and the annual payments of every shall stop. The group may in turn collect from those who cannot pay Yale yet and draw up new terms and conditions for the loan.
3) In 1997 so-called Bowie bonds were issued. These were 10 year bonds paying a 7.9% annual interest coupon, where the money for meeting the payments on the bonds was to come from the future income of musician David Bowie (see http://en.wikipedia.org/wiki/David_bowie if you’ve never heard of him!).
What is the purpose of issuing bonds of this nature (i.e. what’s in it for the issuer)? David Bowie pretty much protected himself to the decline of his popularity. His bonds were issued in exchange for ten years worth of royalties. Bonds were issued in this instance as a security. David Bowie has benefited from this deal, he may or may not have known it at that time but the bonds secured him from music piracy which has plagued the industry at the end of the 90’s.
What risks are investors in the bonds exposed to? After a while, bond investors were exposed to David Bowie’s decline in popularity. Also, they have been exposed to the ultimate enemy of the music industry: piracy. David Bowie issued the bonds on time before website like Kazaa have grown over the internet.
Are their any ways to manage/offset some of these risks? The investors have exposed themselves to the ultimate risk. They have relied too much on the popularity of David Bowie at the time when David Bowie himself protected himself from his decline. Consumer tastes are highly unpredictable and I do not see a way on how the bond investors could have controlled the popularity of music piracy throughout the end of the 90’s and early 2000 when they were supposed to get the royalties.
4) In “The New Financial Order” by Robert Shiller, the author proposes “livelihood” insurance in the form of derivative contracts on the performance of particular professions. In brief, the way it would work is:
-we construct an index which broadly captures the current levels of compensation in a particular profession based on market data. If demand (and salary) for people in a certain profession increases then so would the index, and if demand decreases then so would the index. In other words, the index attempts to capture how good the current career prospects are in that field.
Why might people be interested in contracts valued in this way? Think of both speculation and hedging when considering this question. People might be interested in these kinds of contract because of speculation and hedging. These people are presently employed of course. However, should the demand for their current profession grew, and various companies here and there are offering the same job at a higher compensation, then the person will not be happy at his current job. This kind of insurance will at least get him compensated for that opportunity lost while he stays with his present employer. He speculated that he would gain in the future given that he foresees better-paying opportunities for his career, but it requires a move to another nation or state, so he entered into a contract that would allow him be compensated as he wanted but remain secure in his current position.
How is this proposal different to an individual simply taking out an insurance policy against failing to succeed in his/her chosen profession? (for example, an aspiring musician taking out an insurance contract which pays out if the person never actually ever gets offered a recording contract) This specific example has failure in mind. In the first example, the individual did not have to fail anything. He remains secure in his current position.
Courtney from Study Moose
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