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

Quizplus · Accepted Answer

Adverse selection occurs when the lender has less information about the borrower's potential returns and risks of investment activities, which can lead to the borrower obtaining a loan that they are more likely to default on. This happens because borrowers with riskier projects are more likely to seek out loans and lenders are unable to differentiate between high-risk and low-risk borrowers.

Adverse Selection Is a Problem Associated with Equity and Debt