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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

In Minsky's financial instability hypothesis, which sequence of borrower positions describes the build-up to a crisis as a long boom continues?

The sequence runs from hedge finance, where income covers interest and principal, to speculative finance, where only interest is covered, and finally to Ponzi finance, where borrowers rely on rising asset prices or new debt, making the system fragile.

  1. APonzi finance, then speculative finance, then hedge finance
  2. BSpeculative finance, then hedge finance, then Ponzi finance
  3. CHedge finance, then speculative finance, then Ponzi financeCorrect
  4. DHedge finance, then Ponzi finance, then speculative finance
  5. Ponzi finance remains constant while hedge finance disappears immediately

Explanation

Minsky argued that stability breeds instability. In early recovery borrowers are hedge units whose income covers interest and principal. As confidence grows they become speculative, covering interest only and rolling over principal, and finally Ponzi, needing asset price rises or new borrowing to meet interest. The reverse orderings misstate this deterioration.

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