Question 1

A bank

Accepted Answer

A) Banks can use their information to make better lending decisions and charge higher interest rates, resulting in profits.
B) By making private loans, banks can assess the creditworthiness of the borrower and avoid the free-rider problem that can occur when purchasing securities in the open market.
C) Banks have access to a wide range of information and expertise that allows them to more accurately assess the creditworthiness of borrowers, potentially distinguishing good firms from bad firms.

Question 2

Equity contracts account for a small fraction of external funds raised by American businesses because

Accepted Answer

Costly state verification makes equity contracts less desirable than debt contracts because verifying the true value of equity is difficult and costly. Additionally, there is greater scope for moral hazard problems under equity contracts, as equity holders may take excessive risk without bearing the full consequences. Equity contracts also do not allow for the issuance of additional debt, which decreases their flexibility compared to debt contracts. Therefore, all of the above reasons contribute to why equity contracts account for a small fraction of external funds raised by American businesses.

Question 3

Governments in developing countries sometimes adopt policies that retard the efficient operation of their financial systems. These actions include policies that

Accepted Answer

All three options listed (A, B, and C) are policies that have been adopted by governments in developing countries to retard the efficient operation of their financial systems. Option D includes all three options, making it the correct choice.

Question 4

A debt contract is said to be incentive compatible if

Accepted Answer

The answer of A debt contract is said to be...

Question 5

The principal-agent problem

Accepted Answer

The answer of The principal-agent problem
...

Question 6

Because managers (________)have less incentive to maximize profits than the stockholders-owners (________)do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities.

Accepted Answer

The relationship between managers and stockholders can be explained as a principal-agent relationship, where the stockholders (principals) delegate decision-making authority to the managers (agents). Because managers have less incentive to maximize profits than the stockholders-owners do, there is a risk that managers will act in their own self-interest rather than in the interest of the stockholders. This creates an agency problem and makes it costly for stockholders to monitor managers. Therefore, stockholders are hesitant to purchase equities. This relationship can only be best represented by answer choice D, where managers are agents and stockholders are principals.

Question 7

Liquidity services are services that

Accepted Answer

Liquidity services mainly focus on making it easier for customers to conduct transactions by providing them with tools and platforms to buy and sell assets quickly and efficiently. They do not conduct transactions for customers, and their aim is to lower transaction costs rather than increase them.

Question 8

A venture capital firm protects its equity investment from moral hazard through which of the following means?

Accepted Answer

A venture capital firm protects its equity investment from moral hazard by taking steps to monitor the borrowing firm's activities and by restricting the sale of the equity investment to only the venture capital firm. Placing people on the board of directors and writing contracts that prohibit the sale of the equity investment to anyone other than the venture capital firm are common ways for the venture capital firm to protect its investment. Additionally, prohibiting the borrowing firm from replacing its management can also be a way to mitigate moral hazard, but this is less common. Therefore, both choices A and B are correct, making D the best answer.

Question 9

Bad firms

Accepted Answer

The answer of Bad firms
...

Question 10

Adverse selection

Accepted Answer

Adverse selection is a problem that arises due to asymmetric information before a transaction occurs, where one party has more or better information than the other. It can be mitigated or solved by reducing the information asymmetry between the parties involved, for example, through mechanisms like signaling or screening.

Question 11

Debt contracts

Accepted Answer

Debt contracts involve fixed payments at regular intervals, have lower state verification costs compared to equity contracts, and are more commonly used for raising capital, making all of the provided statements correct.

Question 12

The free-rider problem

Accepted Answer

The free-rider problem encompasses all the issues mentioned: people benefiting from information they haven't paid for, contributing to the lemons problem by not fully solving it through private sales, and hindering the market's ability to produce sufficient information to eliminate asymmetric information, thus preventing adverse selection.

Question 13

A debt contract is more likely to be incentive compatible if

Accepted Answer

The answer of A debt contract is more likely to...

Question 14

Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that

Accepted Answer

Choice A is correct because borrowers may find loopholes or ways to circumvent the restrictions, rendering the covenants ineffective. Choice B is also correct because monitoring and enforcing restrictive covenants can be costly for the lender or debtholder. However, choice C is not a valid concern because it does not diminish the benefits of the covenants. Hence, the correct answer is E.

Question 15

Which of the following are accurate statements concerning the role that restrictive covenants play in reducing moral hazard in financial markets?

Accepted Answer

Restrictive covenants play a crucial role in mitigating moral hazard in financial markets by imposing restrictions on borrowers to prevent undesirable behavior, requiring the maintenance of collateral, and mandating the provision of periodic financial statements. These measures help ensure that borrowers act in the lenders' interests, reducing the risk of default and protecting the lenders' investments.

Question 16

Economies of scale

Accepted Answer

Economies of scale can be used to an advantage by reducing transaction cost. However, it does not explain why financial intermediaries developed and have become such an important part of our financial structure as mentioned in option A.

Question 17

Solutions to the moral hazard problem include

Accepted Answer

The answer of Solutions to the moral hazard problem include
...

Question 18

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of

Accepted Answer

The requirement to purchase homeowner's insurance is a restrictive covenant, as it limits the borrower's use of the property by mandating the purchase of insurance. There is no indication that this requirement is a collusive agreement between mortgage lenders and insurance companies.

Question 19

One financial intermediary in our financial structure that helps to reduce the moral hazard arising from the principal-agent problem is the

Accepted Answer

Venture capital firms help to reduce the moral hazard arising from the principal-agent problem because they typically require entrepreneurs to have a significant personal investment in their business, aligning their interests with those of the venture capitalists. Additionally, venture capitalists typically provide ongoing monitoring and advice, helping to ensure that the funds are being used effectively and in line with their expectations. Money market mutual funds, pawn brokers, and savings and loan associations do not necessarily address the principal-agent problem in the same way as venture capital firms.

Question 20

A debt contract that specifies that the company can only use the funds to finance certain activities

Accepted Answer

A debt contract that specifies that the company can only use the funds to finance certain activities contains a restrictive covenant. This covenant restricts the actions of the borrower and provides protection to the lender by limiting the risk that the borrower will misuse the borrowed funds.

Quiz 7: Why Do Financial Institutions Exist

A bank

Equity contracts account for a small fraction of external funds raised by American businesses because

Governments in developing countries sometimes adopt policies that retard the efficient operation of their financial systems. These actions include policies that

A debt contract is said to be incentive compatible if

The principal-agent problem

Because managers () have less incentive to maximize profits than the stockholders-owners () do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities.

Liquidity services are services that

A venture capital firm protects its equity investment from moral hazard through which of the following means?

Bad firms

Adverse selection

Debt contracts

The free-rider problem

A debt contract is more likely to be incentive compatible if

Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that

Which of the following are accurate statements concerning the role that restrictive covenants play in reducing moral hazard in financial markets?

Economies of scale

Solutions to the moral hazard problem include

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of

One financial intermediary in our financial structure that helps to reduce the moral hazard arising from the principal-agent problem is the

A debt contract that specifies that the company can only use the funds to finance certain activities

Quiz 7: Why Do Financial Institutions Exist

A bank

Equity contracts account for a small fraction of external funds raised by American businesses because

Governments in developing countries sometimes adopt policies that retard the efficient operation of their financial systems. These actions include policies that

A debt contract is said to be incentive compatible if

The principal-agent problem

Because managers (________) have less incentive to maximize profits than the stockholders-owners (________) do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities.

Liquidity services are services that

A venture capital firm protects its equity investment from moral hazard through which of the following means?

Bad firms

Adverse selection

Debt contracts

The free-rider problem

A debt contract is more likely to be incentive compatible if

Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that

Which of the following are accurate statements concerning the role that restrictive covenants play in reducing moral hazard in financial markets?

Economies of scale

Solutions to the moral hazard problem include

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of

One financial intermediary in our financial structure that helps to reduce the moral hazard arising from the principal-agent problem is the

A debt contract that specifies that the company can only use the funds to finance certain activities

Because managers () have less incentive to maximize profits than the stockholders-owners () do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities.