The adverse selection problem in financial markets creates a profit opportunity because
A)it opens a gap between the cost of short-term funds and the cost of long-term funds.
B)it results in the value of a company's stock being well below the value of the company's assets.
C)borrowers are willing to pay to communicate information about their prospects.
D)it makes bond-financed projects cheaper than stock-financed projects.

Question

Quizplus · Accepted Answer

Adverse selection refers to the situation where one party in a transaction has more information than the other, resulting in the other party facing a higher level of risk. In financial markets, this often means that borrowers who are more likely to default are the ones seeking loans. Lenders can take advantage of this by charging higher interest rates to these borrowers, creating a profit opportunity. Additionally, borrowers who are less likely to default may be willing to pay higher interest rates to signal this information to lenders and obtain more favorable terms. Thus, the adverse selection problem creates a profit opportunity for lenders who can successfully identify and lend to borrowers who pose lower risk.

The Adverse Selection Problem in Financial Markets Creates a Profit