The concept of adverse selection helps explain why collateral is an important feature of many debt contracts.

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Adverse selection refers to the potential for borrowers who are riskier than average to be more likely to seek out and obtain loans, while safer borrowers may be less likely to apply. Collateral can help mitigate the effects of adverse selection by providing lenders with security in the event that a borrower defaults on the loan. Therefore, collateral is often included in debt contracts to reduce the risk of adverse selection.

The Concept of Adverse Selection Helps Explain Why Collateral Is