Question 1 (18 marks)
An insurance company is considering issuing three types of car insurance policies:
(i) complete insurance coverage,
(ii) complete coverage above and beyond a $30,000 deductible, and
(iii) 80 percent coverage of all losses.
Which policy is more likely to create moral hazard problems? Explain your answer in details for all
Question 2 (10 marks)
For a certain model of used car, 10% of all owners value their cars at $20,000, 45% at $15,000, 30% at
$10,000, and 15% at $5,000. Suppose a buyer values any car at 1.4 times its value to the seller. However,
while each seller is aware of the value of his car, all used cars appear identical to a buyer.
a. If all four types of used cars are traded, what is the highest price a buyer would be willing to pay, given
that he cannot tell which type of car he is getting ahead of time? Can there be an equilibrium in which all
four types are sold?
b. Can there be an equilibrium in which the three lowest types of used cars are sold? What is the range of
prices that will support mutually beneficial trade in this case?
c. Argue that adverse selection causes this market to partially unravel, such that only the worst used trucks
are traded in any equilibrium.
Question 3 (12 marks) You can buy commercial paper of a major U.S. corporation for $5,950,000. The paper has a face value of $6,000,000 and is 60 days from maturity.
a. Calculate the ask discount yield on the commercial paper and
b. Calculate bond equivalent yield on the commercial paper.
c. Why do commercial paper issuers usually require a credit rating of their issue?
Question 4 (10 marks) On Oct 15, 2021, you purchase a $10,000 T-note that matures on August 15, 2031 (settlement occurs two days after purchase, so you receive actual ownership of the bond on Oct 17, 2021). The coupon rate on the T-note is 4.75% and the current price quoted on the bond is 105:08. The last coupon payment occurred on May 15, 2021, and the next coupon payment will be paid on Nov 15, 2021.
a. Calculate the accrued interest due to the seller from the buyer at settlement.
b. Calculate the dirty price of this transaction.
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