Deck 8: An Economic Analysis of Financial Structure

Question 1

One purpose of regulation of financial markets is to

A)limit the profits of financial institutions.
B)increase competition among financial institutions.
C)promote the provision of information to shareholders,depositors and the public.
D)guarantee that the maximum rates of interest are paid on deposits.

Answer 1

promote the provision of information to shareholders,depositors and the public.

Question 2

Direct finance involves the sale to ________ of marketable securities such as stocks and bonds.

A)households
B)insurance companies
C)pension funds
D)financial intermediaries

Answer 2

households

Question 3

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE?

A)Issuing marketable securities is the primary way that they finance their activities.
B)Bonds are the least important source of external funds to finance their activities.
C)Stocks are a relatively unimportant source of finance for their activities.
D)Selling bonds directly to the American household is a major source of funding for American businesses.

Answer 3

Stocks are a relatively unimportant source of finance for their activities.

Question 4

Collateralized debt is also know as

A)unsecured debt.
B)secured debt.
C)unrestricted debt.
D)promissory debt.

Question 5

Of the sources of external funds for nonfinancial businesses in the United States,stocks account for approximately ________ of the total.

A)2%
B)11%
C)20%
D)40%

Question 6

American businesses get their external funds primarily from

A)bank loans.
B)bonds and commercial paper issues.
C)stock issues.
D)loans from nonbank financial intermediaries.

Question 7

Regulation of the financial system

A)occurs only in the United States.
B)protects the jobs of employees of financial institutions.
C)protects the wealth of owners of financial institutions.
D)ensures the stability of the financial system.

Question 8

As a source of funds for nonfinancial businesses,stocks are relatively more important in

A)the United States.
B)Germany.
C)Japan.
D)Canada.

Question 9

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE?

A)Stocks are a far more important source of finance than are bonds.
B)Stocks and bonds,combined,supply less than one-half of the external funds.
C)Financial intermediaries are the least important source of external funds for businesses.
D)Since 1970,more than half of the new issues of stock have been sold to American households.

Question 10

With regard to external sources of financing for nonfinancial businesses in the United States,which of the following are accurate statements?

A)Marketable securities account for a larger share of external business financing in the United States than in Germany and Japan.
B)Since 1970,most of the newly issued corporate bonds and commercial paper have been sold directly to American households.
C)Direct finance accounts for more than 50 percent of the external financing of American businesses.
D)Smaller businesses almost always raise funds by issuing marketable securities.

Question 11

Nonfinancial businesses in Germany,Japan,and Canada raise most of their funds

A)by issuing stock.
B)by issuing bonds.
C)from nonbank loans.
D)from bank loans.

Question 12

Credit card debt is

A)secured debt.
B)unsecured debt.
C)restricted debt.
D)unrestricted debt.

Question 13

If you default on your auto loan,your car will be repossessed because it has been pledged as ________ for the loan.

A)interest
B)collateral
C)dividend
D)commodity

Question 14

Of the sources of external funds for nonfinancial businesses in the United States,loans from banks and other financial intermediaries account for approximately ________ of the total.

A)6%
B)40%
C)56%
D)60%

Question 15

Of the sources of external funds for nonfinancial businesses in the United States,corporate bonds and commercial paper account for approximately ________ of the total.

A)5%
B)10%
C)32%
D)50%

Question 16

Of the four sources of external funding for nonfinancial businesses,the least often used in the U.S. is

A)bank loans.
B)nonbank loans.
C)bonds.
D)stock.

Question 17

Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called

A)collateral.
B)points.
C)interest.
D)good faith money.

Question 18

The predominant form of household debt is

A)consumer installment debt.
B)collateralized debt.
C)unsecured debt.
D)unrestricted debt.

Question 19

Commercial and farm mortgages,in which property is pledged as collateral,account for

A)one-quarter of borrowing by nonfinancial businesses.
B)one-half of borrowing by nonfinancial businesses.
C)one-twentieth of borrowing by nonfinancial businesses.
D)two-thirds of borrowing by nonfinancial businesses.

Question 20

Of the following sources of external finance for American nonfinancial businesses,the least important is

A)loans from banks.
B)stocks.
C)bonds and commercial paper.
D)loans from other financial intermediaries.

Question 21

An example of the ________ problem would be if Brian borrowed money from Sean in order to purchase a used car and instead took a trip to Atlantic City using those funds.

A)moral hazard
B)adverse selection
C)costly state verification
D)agency

Question 22

How does a mutual fund lower transactions costs through economies of scale?

Question 23

The problem faced by the lender that the borrower may take on additional risk after receiving the loan is called

A)adverse selection.
B)moral hazard.
C)transactions costs.
D)diversification.

Question 24

The presence of ________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets.

A)noncollateralized risk
B)free-riding
C)asymmetric information
D)costly state verification

Question 25

Which of the following is NOT one of the eight basic puzzles about financial structure?

A)Stocks are the most important source of finance for American businesses.
B)Issuing marketable securities is not the primary way businesses finance their operations.
C)Indirect finance,which involves the activities of financial intermediaries,is many times more important than direct finance,in which businesses raise funds directly from lenders in financial markets.
D)Banks are the most important source of external funds to finance businesses.

Question 26

Financial intermediaries develop ________ in things such as computer technology which allows them to lower transactions costs.

A)expertise
B)diversification
C)regulations
D)equity

Question 27

Financial intermediaries' low transaction costs allow them to provide ________ services that make it easier for customers to conduct transactions.

A)liquidity
B)conduction
C)transcendental
D)equitable

Question 28

A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he plans to undertake than does the lender. This inequality of information is called

A)moral hazard.
B)asymmetric information.
C)noncollateralized risk.
D)adverse selection.

Question 29

Which of the following is NOT a benefit to an individual purchasing a mutual fund?

A)reduced risk
B)lower transactions costs
C)free-riding
D)diversification

Question 30

The problem created by asymmetric information before the transaction occurs is called ________,while the problem created after the transaction occurs is called ________.

A)adverse selection;moral hazard
B)moral hazard;adverse selection
C)costly state verification;free-riding
D)free-riding;costly state verification

Question 31

The "lemons problem" exists because of

A)transactions costs.
B)economies of scale.
C)rational expectations.
D)asymmetric information.

Question 32

Because of the "lemons problem" the price a buyer of a used car pays is

A)equal to the price of a lemon.
B)less than the price of a lemon.
C)equal to the price of a peach.
D)between the price of a lemon and a peach.

Question 33

If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of

A)moral hazard.
B)adverse selection.
C)free-riding.
D)costly state verification.

Question 34

A ________ is a provision that restricts or specifies certain activities that a borrower can engage in.

A)residual claimant
B)risk hedge
C)restrictive barrier
D)restrictive covenant

Question 35

The analysis of how asymmetric information problems affect economic behavior is called ________ theory.

A)uneven
B)parallel
C)principal
D)agency

Question 36

Which of the following is NOT one of the eight basic puzzles about financial structure?

A)Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.
B)Indirect finance,which involves the activities of financial intermediaries,is many times more important than direct finance,in which businesses raise funds directly from lenders in financial markets.
C)Collateral is a prevalent feature of debt contracts for both households and business.
D)There is very little regulation of the financial system.

Question 37

By bundling share purchases of many investors together mutual funds can take advantage of economies of scale and thereby lower

A)adverse selection.
B)moral hazard.
C)transactions costs.
D)diversification.

Question 38

The reduction in transactions costs per dollar of investment as the size of transactions increases is

A)discounting.
B)economies of scale.
C)economies of trade.
D)diversification.

Question 39

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

A)proscriptive covenant.
B)prescriptive covenant.
C)restrictive covenant.
D)constraint-imposed covenant.

Question 40

The current structure of financial markets can be best understood as the result of attempts by financial market participants to

A)adapt to continually changing government regulations.
B)deal with the great number of small firms in the United States.
C)reduce transaction costs.
D)cartelize the provision of financial services.

Question 41

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

A)free-rider;adverse selection
B)free-rider;moral hazard
C)principal-agent;adverse selection
D)principal-agent;moral hazard

Question 42

The free-rider problem occurs because

A)people who pay for information use it freely.
B)people who do not pay for information use it.
C)information can never be sold at any price.
D)it is never profitable to produce information.

Question 43

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

A)explains why indirect finance is such an important source of external funds for businesses.
B)can be explained by the problem of moral hazard.
C)can be explained by government regulations that prohibit small firms from acquiring funds in securities markets.
D)explains why newer and smaller corporations rely so heavily on the new issues market for funds.

Question 44

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% loss if the borrower defaults.
C)the borrower's lack of incentive to seek a loan for highly risky investments.
D)the lender's inability to restrict the borrower from changing his behavior once given a loan.

Question 45

Equity contracts

A)are claims to a share in the profits and assets of a business.
B)have the advantage over debt contracts of a lower costly state verification.
C)are used much more frequently to raise capital than are debt contracts.
D)are not subject to the moral hazard problem.

Question 46

Government regulations require publicly traded firms to provide information,reducing

A)transactions costs.
B)the need for diversification.
C)the adverse selection problem.
D)economies of scale.

Question 47

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

A)Federal Communications Commission.
B)Federal Trade Commission.
C)Securities and Exchange Commission.
D)Federal Reserve System.

Question 48

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.

A)financial intermediaries
B)bonds
C)stock
D)direct lending

Question 49

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

A)why firms are more likely to obtain funds from banks and other financial intermediaries,rather than from the securities markets.
B)why indirect finance is more important than direct finance as a source of business finance.
C)why direct finance is more important than indirect finance as a source of business finance.
D)why the financial system is so heavily regulated.

Question 50

The concept of adverse selection helps to explain

A)why collateral is not a common feature of many debt contracts.
B)why large,well-established corporations find it so difficult to borrow funds in securities markets.
C)why financial markets are among the most heavily regulated sectors of the economy.
D)why stocks are the most important source of external financing for businesses.

Question 51

How does collateral help to reduce the adverse selection problem in credit market?

Question 52

The problem of adverse selection helps to explain

A)why firms are more likely to obtain funds from banks and other financial intermediaries,rather than from securities markets.
B)why collateral is an important feature of consumer,but not business,debt contracts.
C)why direct finance is more important than indirect finance as a source of business finance.
D)why lenders refuse loans to individuals with high net worth.

Question 53

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

A)have been afforded special government treatment,since used car dealers do not provide information that is valued by consumers of used cars.
B)are able to prevent potential competitors from free-riding off the information that they provide.
C)have failed to solve adverse selection problems in this market because "lemons" continue to be traded.
D)have solved the moral hazard problem by providing valuable information to their customers.

Question 54

A lesson of the Enron collapse is that government regulation

A)always fails.
B)can reduce but not eliminate asymmetric information problems.
C)increases the problem of asymmetric information.
D)should be reduced.

Question 55

Because of the adverse selection problem

A)good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks.
B)lenders may refuse loans to individuals with high net worth,because of their greater proclivity to "skip town."
C)lenders are reluctant to make loans that are not secured by collateral.
D)lenders will write debt contracts that restrict certain activities of borrowers.

Question 56

The statement "Only the people who don't need money can borrow it!" can be explained by the concept of

A)adverse selection.
B)moral hazard.
C)direct finance.
D)costly state verification.

Question 57

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

A)diversification.
B)government regulations to increase information.
C)the use of financial intermediaries.
D)the private production and sale of information.

Question 58

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

A)increase somewhat.
B)decrease.
C)stay the same.
D)increase significantly.

Question 59

Analysis of adverse selection indicates that financial intermediaries,especially banks

A)have advantages in overcoming the free-rider problem,helping to explain why indirect finance is a more important source of business finance than is direct finance.
B)despite their success in overcoming free-rider problems,nevertheless play a minor role in moving funds to corporations.
C)provide better-known and larger corporations a higher percentage of their external funds than they do to newer and smaller corporations which rely to a greater extent on the new issues market for funds.
D)must buy securities from corporations to diversify the risk that results from holding non-tradable loans.

Question 60

Net worth can perform a similar role to

A)diversification.
B)collateral.
C)intermediation.
D)economies of scale.

Question 61

Explain the principal-agent problem as it pertains to equity contracts.

Question 62

Managers (________)may act in their own interest rather than in the interest of the stockholder-owners (________)because the managers have less incentive to maximize profits than the stockholder-owners do.

A)principals;agents
B)principals;principals
C)agents;agents
D)agents;principals

Question 63

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

A)venture capital firm.
B)money market mutual fund.
C)pawn broker.
D)savings and loan association.

Question 64

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

A)It places people on the board of directors to better monitor the borrowing firm's activities.
B)It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
C)It prohibits the borrowing firm from replacing its management.
D)It requires a 50% stake in the company.

Question 65

The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is

A)costly state verification.
B)the free-rider problem.
C)costly avoidance.
D)debt intermediation.

Question 66

The principal-agent problem would not occur if ________ of a firm had complete information about actions of the ________.

A)owners;customers
B)owners;managers
C)managers;customers
D)managers;owners

Question 67

Although debt contracts require less monitoring than equity contracts,debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like.

A)moral hazard
B)agency theory
C)diversification
D)the "lemons" problem

Question 68

The recent Enron and Tyco International scandals are an example of

A)the free-rider problem.
B)the adverse selection problem.
C)the principal-agent problem.
D)the "lemons problem."

Question 69

Since they require less monitoring of firms,________ contracts are used more frequently than ________ contracts to raise capital.

A)debt;equity
B)equity;debt
C)debt;loan
D)equity;stock

Question 70

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.

A)principal-agent
B)adverse selection
C)free-rider
D)debt deflation

Question 71

High net worth helps to diminish the problem of moral hazard problem by

A)requiring the state to verify the debt contract.
B)collateralizing the debt contract.
C)making the debt contract incentive compatible.
D)giving the debt contract characteristics of equity contracts.

Question 72

The principal-agent problem

A)occurs when managers have more incentive to maximize profits than the stockholders-owners do.
B)in financial markets helps to explain why equity is a relatively important source of finance for American business.
C)would not arise if the owners of the firm had complete information about the activities of the managers.
D)explains why direct finance is more important than indirect finance as a source of business finance.

Question 73

One way the venture capital firm avoids the free-rider problem is by

A)prohibiting the sale of equity in the firm to anyone except the venture capital firm.
B)prohibiting members from serving on the board of directors.
C)prohibiting the borrowing firm from replacing management.
D)requiring collateral equal to the value of the borrowed funds.

Question 74

Debt contracts

A)are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
B)have a higher cost of state verification than equity contracts.
C)are used less frequently to raise capital than are equity contracts.
D)never result in a loss for the lender.

Question 75

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

A)costly state verification makes the equity contract less desirable than the debt contract.
B)of the reduced scope for moral hazard problems under equity contracts,as compared to debt contracts.
C)equity contracts do not permit borrowing firms to raise additional funds by issuing debt.
D)there is no moral hazard problem when using a debt contract.

Question 76

A debt contract is incentive compatible

A)if the borrower has the incentive to behave in the way that the lender expects and desires,since doing otherwise jeopardizes the borrower's net worth in the business.
B)if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.
C)if the debt contract is treated like an equity.
D)if the lender has the incentive to behave in the way that the borrower expects and desires.

Question 77

Government regulations designed to reduce the moral hazard problem include

A)laws that force firms to adhere to standard accounting principles.
B)light sentences for those who commit the fraud of hiding and stealing profits.
C)state verification subsidies.
D)state licensing restrictions.

Question 78

Because information is scarce

A)helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts.
B)monitoring managers gives rise to costly state verification.
C)government regulations,such as standard accounting principles,have no impact on problems such as moral hazard.
D)developing nations do not rely heavily on banks for business financing.

Question 79

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

A)adverse selection;principal-agent
B)moral hazard;principal-agent
C)adverse selection;free-rider
D)moral hazard;free-rider

Question 80

Solutions to the moral hazard in equity contracts include all of the following EXCEPT

A)government regulations to increase information.
B)the use of financial intermediaries.
C)the use of debt contracts.
D)government ownership of resources.