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 percent loss if the borrower defaults
C) the borrower's lack of incentive to seek a loan for highly risky investments
D) the borrower's lack of good options for obtaining funds

Question

Quizplus · Accepted Answer

Adverse selection occurs when the lender does not have enough information about the borrower's potential returns and risks of their investment activities. This may result in the lender offering unfavorable terms, higher interest rates or rejecting the borrower's loan proposal altogether. The borrower typically has more information about their investment activities and may conceal certain negative information, creating an imbalance of information between the two parties.

Adverse Selection Is a Problem Associated with Equity and Debt