Question 1

Equity contracts

Accepted Answer

Equity contracts represent ownership in a business and provide claims to a share in the profits and assets of the business. Debt contracts, on the other hand, represent borrowings and provide claims to a fixed payment. Equity contracts are subject to moral hazard problems, as the owners have an incentive to take excessive risks since they benefit from the upside but do not bear the full downside. While equity contracts may have a lower state verification cost than debt contracts, they are not used more frequently to raise capital.

Question 2

A lesson of the Enron collapse is that government regulation

Accepted Answer

The Enron collapse revealed the problems of asymmetric information in the business world. While government regulation cannot completely eliminate this problem, it can reduce it to some extent through measures such as requiring businesses to disclose financial information to the public. Therefore, Choice B is the best choice. The other choices are incorrect: A is too extreme and does not reflect the nuanced reality of regulation effectiveness, C is incorrect because government regulation can reduce problems of asymmetric information, and D is unsupported by the lesson of the Enron collapse.

Question 3

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 4

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 5

Net worth can perform a similar role to

Accepted Answer

Net worth can serve as collateral for loans and other investments, as it represents the value of a person's assets minus their liabilities.

Question 6

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

Accepted Answer

With the increasing accessibility of online lending platforms, there is a growing trend towards disintermediation in the lending sector. This means that borrowers can directly connect with lenders without involving traditional financial institutions such as banks. As a result, the lending role of banks is likely to decrease over time.

Question 7

The free-rider problem occurs because

Accepted Answer

The free-rider problem occurs because people who do not pay for information still benefit from it, without contributing to its production. This creates a disincentive to produce information because it is not profitable to invest resources in something that others can use for free.

Question 8

Government regulations require publicly traded firms to provide information,reducing

Accepted Answer

Government regulations requiring publicly traded firms to provide information helps to reduce the adverse selection problem. This is because it increases the transparency of the firm's operations and financial performance, making it easier for potential investors to make informed decisions about whether or not to invest in the company. Without regulations, there may be asymmetric information between the company and its investors, leading to potentially harmful investment decisions.

Question 9

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 10

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 11

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 and ensuring that firms that sell securities in public markets follow standard accounting principles and disclose information about their sales, assets, and earnings. The Federal Communications Commission (FCC) regulates communication networks, the Federal Trade Commission (FTC) enforces consumer protection laws, and the Federal Reserve System is responsible for monetary policy and regulating banks.

Question 12

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 service or good without paying for it, which leads to an underproduction of the good. In the case of information, individuals can obtain it without paying for it, which can undo the private incentives for firms to produce and sell that information. The adverse selection problem, on the other hand, occurs when one party to a transaction has better information than the other party, leading to an unequal distribution of risk. While adverse selection can also undermine the production and sale of information, it is not directly related to the free-rider problem. The principal-agent problem concerns agency relationships, where the principal hires an agent to act on their behalf. The moral hazard problem arises when the agent has an incentive to act in their own interests and not in the interests of the principal. While it is possible for information problems to exacerbate moral hazard, this is again not directly related to the free-rider problem.

Question 13

The problem of adverse selection helps to explain

Accepted Answer

Adverse selection refers to the problem of lenders not having enough information about borrowers, causing them to choose the wrong borrowers or charge higher interest rates. This problem is more prevalent in securities markets where borrowers have easier access to funds without being thoroughly vetted. Therefore, firms are more likely to obtain funds from banks and other financial intermediaries, which provide services such as credit analysis and risk assessment to reduce adverse selection.

Question 14

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 or microfinance institutions, can play a vital role in providing financing to private firms in developing countries, especially when information about these firms is difficult to collect or verify. In contrast, in industrialized countries, stock and bond markets may be more developed and provide more opportunities for firms to access external financing. Direct lending may also be more common in industrialized countries where there are more developed and diversified financial markets.

Question 15

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 16

Because of the adverse selection problem

Accepted Answer

The answer of Because of the adverse selection problem
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Question 17

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

Accepted Answer

Adverse selection occurs when the lender has less information about the borrower's potential returns and risks of their investment activities, leading to a higher likelihood of default. This is because borrowers who are more likely to default may be more willing to accept high-cost loans, while those who are more likely to repay may seek lower-cost loans elsewhere. This results in a situation where the lender is more likely to be stuck with high-risk borrowers who are more susceptible to default.

Question 18

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

Accepted Answer

The fact that most used cars are sold by intermediaries such as used car dealers suggests that they are able to prevent potential competitors from free-riding off the information they provide. In other words, since used car dealers have access to more information about the cars they sell, they are able to establish themselves as trusted intermediaries for buyers and sellers alike. This helps to reduce the risk of adverse selection, whereby buyers purchase "lemons" because they don't have enough information about the car's quality. However, it's worth noting that this still doesn't completely solve the adverse selection problem, as some "lemons" may still be traded.

Question 19

Tools to help solve the adverse selection problem in financial markets include all of the following EXCEPT

Accepted Answer

Diversification is a strategy used to reduce risk by allocating investments among various financial instruments, industries, and other categories. It does not directly address the adverse selection problem, which involves asymmetric information between buyers and sellers. Government regulations, financial intermediaries, and the private production and sale of information all aim to reduce information asymmetry, thereby mitigating adverse selection.

Question 20

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

Accepted Answer

Adverse selection suggests that those who are most likely to seek out funding are those who are the riskiest, which can lead to asymmetric information and a higher likelihood of default. This makes it more difficult for firms to obtain funding directly from investors in the securities markets, as they may be seen as too risky. As a result, firms are more likely to obtain funds from banks and other financial intermediaries, which can help to mitigate the risks associated with adverse selection. Additionally, adverse selection can help to explain why the financial system is heavily regulated, as regulators seek to prevent asymmetric information and ensure that investors have access to accurate and reliable information when making investment decisions.

Quiz 8: An Economic Analysis of Financial Structure