Recently, the housing market suffered the worst slump in nearly two decades. Hot housing markets like Boston, Ft. Lauderdale Florida, and Washington DC cooled as rising interest rates and tightened lending standards eliminated lots of potential buyers. With job losses in the auto industry, the housing downturn was especially serious in Detroit and surrounding areas. Suppose a real estate speculator seeking to profit from the downturn bought a pool of home mortgages for $1 million on the expectation of quickly selling them to out-of-town investors for $1.5 million. If the deal falls through, the speculator would be able to just as quickly dump the pool of home mortgages in the secondary market for $800,000.
A. Calculate the speculator’s expected payoff if there is a 50/50 chance of successfully selling the pool of home mortgages to out-of-town investors.
B. Calculate the certainty equivalent adjustment factor for this investment. Is the speculator’s decision to buy the pool of home mortgages consistent with risk adverse behavior?