# Intro to Econ: Ninth Lecture Aside – The Winner’s Curse

For one last time, I want to come back to the problem of whether you get a loan for your project under the assumption that the risk inherent in your project is stochastically independent of other investment risks. So this was our problem (see also here and here):

$\begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular},$

where $x$ is the repayment amount that you pay back to the investor in case of the project being successful. We argued (in a previous post) that the range of feasible interest rates is 12,5% to 200%. Anything outside that will certainly not be accepted by either the investor or by you.

Suppose that you and the investor are close to agreeing to an interest rate of just over 12,5%. Put yourself in the shoes of the investor for a moment. What might worry you in this case?

# Intro to Econ: Ninth Lecture Aside – Moral Hazard

I want to briefly come back to the problem of whether you get a loan for your project under the assumption that the risk inherent in your project is stochastically independent of other investment risks. So this was our problem (see also here and here):

$\begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular},$

where $x$ is the repayment amount that you pay back to the investor in case of the project being successful. We argued (in a previous post) that the range of feasible interest rates is 12,5% to 200%. Anything outside that will certainly not be accepted by either the investor or by you.

Suppose that you and the investor are close to agreeing to an interest rate of almost 200%. Put yourself in the shoes of the investor for a moment. What might worry you in this case?

# Intro to Econ: Ninth Lecture – Risk Premia under Independent Risks

In the previous post we had the following problem. We were wondering about which interest rate we could expect to see for a loan for a particular risky project. You would like to get a loan, and an investor might like to give it to you. The question was, under what conditions you would get this loan, if you get it at all. Recall, that your project can turn out to be good or bad and that investors generally agree about the chances and consequences of either outcome. The problem can be summarized by the following table, where $x$ is the repayment amount that you pay back to the investor in case of the project being successful. If it is unsuccessful you pay nothing, because you have nothing. You “default” on your loan in that case. This is the risk the investor takes on when she or he gives you this loan.

$\begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular}$

We figured out that you will not accept the loan if the repayment amount $x$ is more than € 200.000 (that would be an interest rate of 200%). Because then you have nothing to gain from this project. In reality, you might not even accept anything close to 200%, but we will come back to this problem later.

We also figured out that the investor will (almost) certainly not accept an interest rate below 12.5%, as otherwise the investor expects a negative return on their investment and would then be better off just putting her or his money under a mattress or, I guess, in a safe or vault. By the way, for a very long time the Catholic Church (and other religions) considered positive interest rates morally wrong. In such a world, you probably wouldn’t get a loan for your great project, unless you find a way around this problem. And that would probably be a shame (see previous post).

In this post I want to think about whether an investor will really accept an interest of 12.5% (or slightly above) given that the investor now takes all the risk and at an interest rate of 12.5% only expects a zero return. The answer to this question, it turns out, all depends on whether the risk in this project is essentially stochastically independent of all other risks inherent in all other projects or not.

# Intro to Econ: Ninth Lecture – Credit Markets – Financial Markets

So far we talked a bit abstractly about markets. Yes, we used some specific products for examples, such as white wine, rental apartments, and perhaps airline pricing, but we have not yet developed a particular market model specifically for a particular product. In this post, I want to do this for a particularly important market: the market for money. This post gives a first account of the basic insights and ingredients that underlie our understanding of credit markets and financial markets. You will see, I hope, that what we have learned so far, especially about supply and demand, while not enough to understand these markets fully, was also not in vain. It will come in handy.