Question 1

How does collateral help to reduce the adverse selection problem in credit market?

Accepted Answer

The answer of How does collateral help to reduce the...

Question 2

Because of the adverse selection problem,
A)good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks.
B)lenders may refuse loans to individuals with high net worth,because of their greater proclivity to "skip town."
C)lenders are reluctant to make loans that are not secured by collateral.
D)lenders will write debt contracts that restrict certain activities of borrowers.

Accepted Answer

The answer of Because of the adverse selection problem,
A)good credit...

Question 3

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.
A)principal-agent
B)adverse selection
C)free-rider
D)debt deflation

Accepted Answer

The principal-agent problem refers to the conflict of interest that arises when one party (the principal) hires another party (the agent) to act on their behalf. In equity contracts, the managers of the firm (the agents) may engage in moral hazard, where they have fewer incentives to maximize profits than the stockholders (the principals) would ideally prefer. This can lead to a misalignment of interests and potentially harmful behavior by the managers.

Question 4

A problem for equity contracts is a particular type of ________ called the ________ problem.
A)adverse selection; principal-agent
B)moral hazard; principal-agent
C)adverse selection; free-rider
D)moral hazard; free-rider

Accepted Answer

The correct answer is moral hazard; principal-agent problem. This problem arises when there is a conflict of interest between a principal (e.g., a shareholder) and an agent (e.g., a company's executive), where the agent has an incentive to act in their own best interests rather than those of the principal, especially when the principal cannot perfectly monitor the agent's actions.

Question 5

Equity contracts
A)are claims to a share in the profits and assets of a business.
B)have the advantage over debt contracts of a lower costly state verification.
C)are used much more frequently to raise capital than are debt contracts.
D)are not subject to the moral hazard problem.

Accepted Answer

Equity contracts represent ownership in a business, so the holder of such a contract has a claim to a share in the profits and assets of the business. Option B is incorrect because equity contracts typically require more costly monitoring and verification processes than debt contracts. Option C is also incorrect because debt contracts are generally more common for raising capital. Option D is incorrect because moral hazard can still exist in equity contracts if managers prioritize their own interests over those of the shareholders.

Question 6

Government regulations require publicly traded firms to provide information,reducing
A)transactions costs.
B)the need for diversification.
C)the adverse selection problem.
D)economies of scale.

Accepted Answer

Government regulations that require publicly traded firms to provide information help to reduce the adverse selection problem. This is because these regulations force companies to disclose important information about their operations and financial performance, making it easier for investors to make informed decisions about whether to invest or not. Without this information, investors would be more likely to face uncertainty and potentially make poor investment decisions, leading to adverse selection.

Question 7

Net worth can perform a similar role to
A)diversification.
B)collateral.
C)intermediation.
D)economies of scale.

Accepted Answer

Net worth can act as collateral for loans, allowing individuals and businesses to access credit or financial resources that they may not have been able to otherwise. It serves as a form of security or assurance for lenders or investors, making them more willing to provide financing.

Question 8

Analysis of adverse selection indicates that financial intermediaries,especially banks,
A)have advantages in overcoming the free-rider problem,helping to explain why indirect finance is a more important source of business finance than is direct finance.
B)despite their success in overcoming free-rider problems,nevertheless play a minor role in moving funds to corporations.
C)provide better-known and larger corporations a higher percentage of their external funds than they do to newer and smaller corporations which rely to a greater extent on the new issues market for funds.
D)must buy securities from corporations to diversify the risk that results from holding non-tradable loans.

Accepted Answer

Adverse selection refers to situations where buyers have less information than sellers, leading to the potential for the selection of poor-quality goods or services. Financial intermediaries such as banks have advantages in overcoming the free-rider problem by collecting and sharing information about borrowers, which helps to screen out bad borrowers and reduce adverse selection. This helps to explain why indirect finance (via financial intermediaries) is a more important source of business finance than is direct finance (via securities markets).

Question 9

In the United States,the government agency requiring that firms that sell securities in public markets adhere to standard accounting principles and disclose information about their sales,assets,and earnings is the
A)Federal Communications Commission.
B)Federal Trade Commission.
C)Securities and Exchange Commission.
D)Federal Reserve System.

Accepted Answer

The Securities and Exchange Commission (SEC) is the government agency responsible for regulating the sale of securities in public markets. They enforce regulations requiring firms to follow standard accounting principles and disclose information about their financial performance. The Federal Communications Commission (FCC) regulates telecommunications, the Federal Trade Commission (FTC) enforces consumer protection laws, and the Federal Reserve System regulates monetary policy and oversees banks.

Question 10

The free-rider problem occurs because
A)people who pay for information use it freely.
B)people who do not pay for information use it.
C)information can never be sold at any price.
D)it is never profitable to produce information.

Accepted Answer

The free-rider problem occurs when individuals benefit from a public good without paying for it. In the case of information, once it is produced and made available, it can be used by anyone without necessarily paying for it. This creates a problem for producers who may be reluctant to invest in creating information products since they may not be able to recoup their costs.

Question 11

Adverse selection is a problem associated with equity and debt contracts arising from
A)the lender's relative lack of information about the borrower's potential returns and risks of his investment activities.
B)the lender's inability to legally require sufficient collateral to cover a 100% loss if the borrower defaults.
C)the borrower's lack of incentive to seek a loan for highly risky investments.
D)the lender's inability to restrict the borrower from changing his behavior once given a loan.

Accepted Answer

Adverse selection occurs when the lender lacks information about the borrower's potential returns and risks. This can lead to a situation where only high-risk borrowers seek out loans, leaving the lender with a portfolio of risky investments. The lender may have difficulty assessing the riskiness of borrowers' investment activities, leading to suboptimal loan agreements.

Question 12

The ________ problem helps to explain why the private production and sale of information cannot eliminate ________.
A)free-rider; adverse selection
B)free-rider; moral hazard
C)principal-agent; adverse selection
D)principal-agent; moral hazard

Accepted Answer

The free-rider problem arises when individuals can benefit from a good or service without contributing to its production or cost. In the context of information, this means that individuals may use free, publicly available information rather than paying for private information, which leads to underproduction of private information. Adverse selection occurs when one party has more information than the other and uses it to take advantage of the less informed party, which cannot be eliminated even with private production and sale of information.

Question 13

The concept of adverse selection helps to explain
A)why collateral is not a common feature of many debt contracts.
B)why large,well-established corporations find it so difficult to borrow funds in securities markets.
C)why financial markets are among the most heavily regulated sectors of the economy.
D)why stocks are the most important source of external financing for businesses.

Accepted Answer

Adverse selection refers to a situation where sellers have information that buyers do not, or vice versa, about some aspect of product quality. In the context of financial markets, this can lead to market failure as bad credit risks are more likely to seek loans than good credit risks, prompting lenders to protect themselves. This problem is a key reason financial markets are heavily regulated, to ensure information is disclosed and to protect against market failures caused by information asymmetries.

Question 14

A lesson of the Enron collapse is that government regulation
A)always fails.
B)can reduce but not eliminate asymmetric information.
C)increases the problem of asymmetric information.
D)should be reduced.

Accepted Answer

The collapse of Enron highlighted the issue of asymmetric information, where insiders had access to information that the general public did not. Government regulation can help reduce this issue, but not completely eliminate it. The lesson learned is that regulation is necessary but may not be sufficient to prevent corporate misconduct.

Question 15

External financing by ________ should be more important in developing countries than in industrialized countries because information about private firms is more difficult to collect in developing countries.
A)financial intermediaries
B)bonds
C)stock
D)direct lending

Accepted Answer

Financial intermediaries, such as banks and other financial institutions, can help bridge the gap between investors and firms in developing countries where information about private firms may be more difficult to collect. In industrialized countries, there may be more options for firms to access external financing through stock and bond markets or direct lending.

Question 16

That only large,well-established corporations have access to securities markets
A)explains why indirect finance is such an important source of external funds for businesses.
B)can be explained by the problem of moral hazard.
C)can be explained by government regulations that prohibit small firms from acquiring funds in securities markets.
D)explains why newer and smaller corporations rely so heavily on the new issues market for funds.

Accepted Answer

Indirect finance is crucial for businesses, especially smaller ones, because direct access to securities markets is often limited to larger, well-established corporations. This makes banks and other financial intermediaries key sources of external funds for these smaller entities.

Question 17

The concept of adverse selection helps to explain all of the following except
A)why firms are more likely to obtain funds from banks and other financial intermediaries,rather than from the securities markets.
B)why indirect finance is more important than direct finance as a source of business finance.
C)why direct finance is more important than indirect finance as a source of business finance.
D)why the financial system is so heavily regulated.

Accepted Answer

Adverse selection is a phenomenon where one party in a transaction has more information than the other and uses that information to their advantage. This can lead to the selection of poor quality assets by investors or lenders. However, this concept does not explain why direct finance is more important than indirect finance as a source of business finance.

Question 18

The problem of adverse selection helps to explain
A)why firms are more likely to obtain funds from banks and other financial intermediaries,rather than from securities markets.
B)why collateral is an important feature of consumer,but not business,debt contracts.
C)why direct finance is more important than indirect finance as a source of business finance.
D)why lenders refuse loans to individuals with high net worth.

Accepted Answer

Adverse selection refers to the problem of lenders not being able to distinguish between high-risk borrowers and low-risk borrowers when they seek funds. This makes it difficult for lenders to offer loans at competitive interest rates, which in turn makes it difficult for borrowers to obtain funds. Banks and other financial intermediaries are better equipped to deal with adverse selection because they can gather more information about borrowers than securities markets. Thus, borrowers are more likely to obtain funds from banks and other financial intermediaries than from securities markets.

Question 19

That most used cars are sold by intermediaries (i.e.,used car dealers)provides evidence that these intermediaries
A)have been afforded special government treatment,since used car dealers do not provide information that is valued by consumers of used cars.
B)are able to prevent potential competitors from free-riding off the information that they provide.
C)have failed to solve adverse selection problems in this market because "lemons" continue to be traded.
D)have solved the moral hazard problem by providing valuable information to their customers.

Accepted Answer

The answer of That most used cars are sold by...

Question 20

As information technology improves,the lending role of financial institutions such as banks should
A)increase somewhat.
B)decrease.
C)stay the same.
D)increase significantly.

Accepted Answer

As information technology improves, it becomes easier and more efficient for alternative online lenders to enter the market and offer competitive rates to customers. This increase in competition will likely decrease the lending role of traditional financial institutions such as banks.

Quiz 8: An Economic Analysis of Financial Structure

How does collateral help to reduce the adverse selection problem in credit market?

Because of the adverse selection problem,

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.

A problem for equity contracts is a particular type of called the problem.

Equity contracts

Government regulations require publicly traded firms to provide information,reducing

Net worth can perform a similar role to

Analysis of adverse selection indicates that financial intermediaries,especially banks,

In the United States,the government agency requiring that firms that sell securities in public markets adhere to standard accounting principles and disclose information about their sales,assets,and earnings is the

The free-rider problem occurs because

Adverse selection is a problem associated with equity and debt contracts arising from

The problem helps to explain why the private production and sale of information cannot eliminate .

The concept of adverse selection helps to explain

A lesson of the Enron collapse is that government regulation

External financing by ________ should be more important in developing countries than in industrialized countries because information about private firms is more difficult to collect in developing countries.

That only large,well-established corporations have access to securities markets

The concept of adverse selection helps to explain all of the following except

The problem of adverse selection helps to explain

That most used cars are sold by intermediaries (i.e.,used car dealers) provides evidence that these intermediaries

As information technology improves,the lending role of financial institutions such as banks should