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) none of the above.

Question

Quizplus · Accepted Answer

Adverse selection occurs when one party in a transaction has more information than the other party, resulting in the second party being at a disadvantage. In the case of equity and debt contracts, adverse selection arises because the lender may not have enough information about the borrower's potential returns and risks, leading to the possibility of lending money to high-risk borrowers who are likely to default.

Adverse Selection Is a Problem Associated with Equity and Debt