ECO 342 Banking & Financial Markets Homework #3 Answer Key

1. We observe that in the past 20 years, corporations have shifted away from defined benefit plans in favor of defined contribution plans.  Why have firms found this shift attractive?

Defined benefit plans are a huge liability for firms.  Firms must fund the plan to pay out promised vested benefits, reguardless of investment performance of the assets.  However, for defined contribution plans , the firm is at most responsible for a matching contribution and does not bear any investment risk.
2. Consider the problems faced by Social Security in the U.S. and the potential solutions
a) [Based on Chapter 9, #10]Briefly discuss the role played by demographics in the current problem.
The U.S. population is aging and life expectancies are rising.  This means that (1) there will be fewer workers paying into Social Security relative to those receiving benefits, and (2) retirees will be receiving benefits over a longer period of time.  Due to these two factors, Social Security payroll taxes will not be sufficient to fund benefits within the next 20 years.
b) Recently, Fed Chair Alan Greenspan suggested cutting Social Security to benefits as a possible solution to the problem.  Of the solutions discussed in class, which one do you believe is best?  Explain your answer.
Possible solutions to discuss included:
--raising the retirement age
--cutting benefits
--increasing payroll taxes
--establishing private 401k-type accounts
--investing the current Social Security surplus in the stock market rather than Treasury IOUs.
3. Consider a zero-coupon bond (a discount bond) with a $10,000 face value and a maturity of 75 days.
a) If the bond is purchased for $9960, what is the yield to maturity? (bond equivalent basis)
[(10,000/9960) - 1](365/75) = .0195 = 1.95%
b) If the bond's yield is 3%, what is it's price? (bond equivalent basis)
10,000/[1 + (.03)(75/365)] = 9938.73
4. Consider the properties affecting asset prices.  Contrast moneyness, reversibility, and liquidity.  Are these desirable properties?  How are they related?
Moneyness refers to whether an asset can be used as a medium of exchange, or easily converted to money.  Reversibility is the cost of investing in asset, then selling it for cash.  Liquidity refers to how easy and cheap is the asset to buy/sell?  Moneyness, liquidity, and a low cost of reversibility are all desirable properties for an asset.  All 3 properties are closely related in they all deal with how "close" an asset is too cash and the costs involved in trying to quickly convert an asset to cash.  An asset that has moneyness will necessarily be liquid and easily reversible.