In a market for bonds, buyers value AAA bonds at $10,000, and AA bonds at $8,000

Question

In a market for bonds, buyers value AAA bonds at $10,000, and AA bonds at $8,000. Sellers value AAA ones at $8,400, and AA ones at $6,100. If a buyer cannot observe bond type prior to purchase, and believes 40% are type AAA, then the maximum price the buyer would be willing to pay is $8,800 $8,150 $7,910 $7,510 Consider the bond market in problem 6. What is the minimum fraction of type AAA bonds needed in order to sustain trade in both types of bonds and avoid adverse selection? 0.2 0.25 0.3 0.5 Consider the bond market in problem 6. Sellers of AAA bonds can guarantee them at a cost of $50 per n, and sellers of AA bonds can guarantee them at a cost of $350 per n, where n is the number of months for which the guarantee applies. Find the lowest acceptable n value that will allow the seller of AAA to signal his type. 11 9 8 5

Explanation / Answer

Multiple questions asked.

First question is answered below.

6.

Willigness to pay for AAA bonds = $10,000

Willingness to pay for AA bonds = $8000

Expected probability of AAA bonds = 40%

Expected probability of AA bonds = 1-40% = 60%

Thus, buyers valuation of bonds = 40% of $1000 + 60% of $8000 = 4000+4800 = $8800

Hence, correct option is (a) $8800

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