Question 1

Equity contracts

Accepted Answer

Equity contracts represent ownership in a business and provide the holder with a claim to a share in the profits and assets of the business. Unlike debt contracts, which are a form of borrowing that creates an obligation to make fixed payments to creditors, equity investments do not generally involve the same level of state verification and are not subject to the same moral hazard problems. However, equity contracts also carry higher risk and uncertainty for investors, as the value of the investment depends on the success of the underlying business.

Question 2

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.

Accepted Answer

Moral hazard in equity contracts is commonly referred to as the principal-agent problem, where the interests of the manager (the agent) may not align with the interests of the stockholders (the principals). The manager may have less of an incentive to maximize profits and may act in their own self-interest, which can lead to a divergence in goals between the manager and stockholders.

Question 3

Because of the adverse selection problem,

Accepted Answer

The answer of Because of the adverse selection problem,
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Question 4

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

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

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

Accepted Answer

With the advancement of technology, online lending platforms have emerged and gained popularity. This has reduced the reliance on traditional banks for loans. Therefore, the lending role of financial institutions such as banks is expected to decrease.

Question 6

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

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 7

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.

Accepted Answer

Financial intermediaries, such as banks and microfinance institutions, can gather information about potential borrowers and assess their creditworthiness even when information is scarce or incomplete. This is especially important in developing countries where private firms may not have the same level of transparency and public disclosure requirements as in industrialized countries. Bond and stock markets are typically not as developed in developing countries, and direct lending may be risky without proper information and analysis.

Question 8

Government regulations require publicly traded firms to provide information, reducing

Accepted Answer

Publicly traded firms may have an adverse selection problem where investors are unable to distinguish between good and bad investments. Government regulations that require firms to provide information such as financial statements and annual reports can help reduce this problem by providing investors with the necessary information to make informed decisions. It does not necessarily reduce transaction costs, the need for diversification, or economies of scale.

Question 9

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

Accepted Answer

Adverse selection occurs when one party in a transaction (in this case, the lender) has less information than the other party (the borrower) about the potential returns and risks of an investment. This can lead to the lender offering terms that are disadvantageous to their interests or ultimately rejecting the investment. This can lead to a situation where only the riskiest borrowers seek out loans, which increases the likelihood of default and loss for the lender.

Question 10

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 11

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

Accepted Answer

Adverse selection does not explain why direct finance is more important than indirect finance as a source of business finance. Instead, adverse selection helps explain why indirect finance is more important than direct finance, as financial intermediaries are able to pool and diversify risk, thereby mitigating adverse selection problems.

Question 12

The free-rider problem occurs because

Accepted Answer

The free-rider problem occurs when individuals benefit from a public good (such as information) without contributing to its production. Therefore, choice B (people who do not pay for information use it) is the best answer. Choices A, C, and D do not accurately describe the free-rider problem.

Question 13

The concept of adverse selection helps to explain

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

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

Accepted Answer

Financial intermediaries, especially banks, have advantages in overcoming the free-rider problem, which is one reason why indirect finance is more important than direct finance for businesses. This is because intermediaries can pool resources and conduct in-depth analyses that individual investors might not undertake due to the costs involved, thus mitigating adverse selection issues.

Question 15

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

Accepted Answer

The Securities and Exchange Commission (SEC) is the government agency responsible for regulating securities markets in the United States. It requires public companies to adhere to generally accepted accounting principles and disclose information about their sales, assets, and earnings to investors in order to promote transparency and protect investors. The other options listed are not relevant to securities regulation.

Question 16

A lesson of the Enron collapse is that government regulation

Accepted Answer

The Enron collapse demonstrated the problem of asymmetric information in the financial sector. While government regulation cannot completely eliminate this problem, it can reduce it to some extent. The lesson is not that government regulation always fails or should be reduced, but rather that it is necessary to strike a balance between regulation and market freedom to ensure proper functioning of the financial markets.

Question 17

Net worth can perform a similar role to

Accepted Answer

Net worth can serve as collateral for loans, providing a source of security for lenders. This can enable individuals or businesses to access financing that they might not otherwise be able to obtain. Net worth can also provide a measure of financial stability, which can be valuable in various contexts, from personal financial planning to corporate creditworthiness. While diversification, intermediation, and economies of scale are also important concepts in finance and economics, they do not directly correspond to the role that net worth plays in lending and financial markets.

Question 18

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

Accepted Answer

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

Question 19

The problem of adverse selection helps to explain

Accepted Answer

Adverse selection refers to the problem of potentially selecting risky borrowers who are more likely to default on their loans. Securities markets may have a higher risk of adverse selection due to the difficulty of identifying the creditworthiness of potential borrowers. Therefore, firms may turn to financial intermediaries like banks who can use their expertise to select less risky borrowers and mitigate the problem of adverse selection.

Question 20

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

Accepted Answer

The free-rider problem occurs when individuals can benefit from a good or service without paying for it. In the case of information, if it were privately produced and sold, some individuals may choose not to purchase it but still use it, thus becoming free-riders. Adverse selection occurs when information asymmetry leads to the market being dominated by low-quality goods or services. In the case of information, even if it is privately produced and sold, individuals may still have less information than the sellers, leading to adverse selection. Therefore, the private production and sale of information cannot eliminate these problems.

Quiz 8: An Economic Analysis of Financial Structure