Moral hazard is a problem associated with debt and equity contracts arising from
A) the borrower's incentive to undertake highly risky investments.
B) the owners' inability to ensure that managers will act in the owners' interest.
C) the difficulty lenders have in sorting out good credit risks from bad credit risks.
D) all of the above.
E) only A and B of the above.

Question

Quizplus · Accepted Answer

Moral hazard refers to the risk that one party may take excessive risks when they have protection against losses. In the context of debt and equity contracts, moral hazard arises when the borrower (or management, in the case of equity) has an incentive to undertake highly risky investments that may benefit the borrower themselves, but may not necessarily benefit the lender (or owners). This can happen because the borrower (or management) may not bear the full cost of losses if the investments do not pay off.

Both choices A and B capture different aspects of this problem - choice A highlights the borrower's incentive to take excessive risks, while choice B refers to the difficulty that owners have in ensuring that management acts in the owners' interest. Therefore, the correct answer is E, only A and B of the above.

Choice C refers to adverse selection, which is a related but distinct problem that arises when lenders cannot tell good credit risks from bad ones. Therefore, it is not directly connected to the problem of moral hazard.

Moral Hazard Is a Problem Associated with Debt and Equity