Money and Banking Ch. 9 TB

By reducing transactions and information costs, financial intermediaries can

A) offer savers higher interest rates. B) offer borrowers lower interest rates. C) earn a profit. D) all of the above. Answer: D

Which of the following does NOT represent a way in which financial intermediaries take advantage of economies of scale?

A) paying lower brokerage fees per dollar invested B) paying lower legal fees per dollar invested C) purchasing sophisticated computer systems D) paying lower taxes per dollar invested Answer: D

All of the following are benefits of securitization EXCEPT

A) risk sharing. B) reduced interest rates that borrowers pay on loans. C) increased liquidity. D) fewer adverse selection problems. Answer: A

All of the following are consequences of adverse selection on good firms EXCEPT

A) the cost of external financing increases. B) firms need to rely more on internal funds. C) firms need to rely more on accumulated profits. D) firms will only be able to attain financing from the government. Answer: D

Smaller firms tend to rely on financial intermediaries instead of financial markets for external financing due to

A) transactions costs. B) adverse selection. C) moral hazard. D) all of the above. Answer: D

Why do higher interest rates increase adverse selection problems in the loan market?

As interest rates rise, the creditworthiness of the average loan applicant declines.

Which of the following agencies has established standardized accounting principles for reporting corporate earnings?

The Securities and Exchange Commission

When interest rates in the bond market rise,

adverse selection problems increase.

Requirements for information disclosure for firms that desire to sell securities in financial markets

are very common in industrialized countries, including the United States.

A firm's net worth is equal to the value of its

assets minus the value of its liabilities.

Suppose some members of Enron's board of directors are aware of the company's true financial condition, information that is not available to most investors. This is an example of

asymmetric information.

Credit rationing refers to

a restriction in the availability of credit.

The main reason why banks are the leading source of external finance for businesses is

banks have an information-cost advantage in reducing adverse selection problems.

Which of the following is the most important source of external financing for corporations?

bond market

When there's asymmetric information, who tends to have the better information?

borrower

Moral hazard problems arise when

borrowers have an incentive to act in ways that do not reflect the lender's interests.

Moral hazard is not eliminated in debt financing because

borrowers have an incentive to assume greater risk than is in the interest of the lender.

Moral hazard problems arise when

borrowers have an incentive to conceal information.

The assumption of asymmetric information means that

borrowers know more than lenders

The reduction in transactions costs brought about by financial intermediaries benefits

both small savers and small borrowers.

A market maker

brings together buyers and sellers of a financial asset.

In effect, banks are able to charge

depositors for banks' superior information about borrowers.

To help offset the costs from loan defaults, the First National Bank of Gotham decides to increase the interest rate it charges on its business loans. As a result of this increase in the interest rate, the creditworthiness of Gotham's loan applicants is likely to

deteriorate

The "lemons problem" exists in the market for goods because

differences in the quality of the goods being exchanged.

Banks require collateral for loans in order to

ensure that borrowers have significant amounts of their own funds invested in their businesses.

The company that manufactures Screaming Chocolate Zonkers breakfast cereal finds that its sales collapse, it is forced into bankruptcy, and it defaults on its bonds, as a result of information on the filthy conditions in its factory, which had long been known to management, leaking out to the general public. This incident is best thought of as an example of

example of asymmetric information in the financial markets

Suppose one person buys a copy of Consumer Reports and gives away free copies to all who request one. This is an example of

free rider problem.

Banks deal with problems of adverse selection by

gathering information about the default risk of borrowers.

Venture capital firms attempt to overcome the principal-agent problem by

holding large equity stakes in the firms they invest in.

Information costs

include the costs that savers incur to determine the credit worthiness of borrowers.

Government regulations requiring firms that desire to sell securities in financial markets to disclose all available information

increase the difficulty that young firms may have in raising funds.

Private information-collection firms fail to eliminate the adverse selection problem because

some investors who do not pay for their services will still profit from them.

In the late 2000s, the primary source of external funds for corporations was

stocks

Financial intermediaries reduce transactions costs by

taking advantage of economies of scale.

Transactions costs are

the costs of direct financial transactions.

The "lemons problem" in the used car market arises from

the difficulty buyers have in distinguishing good cars from lemons.

Financial intermediaries are able to exploit economies of scale since

the equipment or expertise necessary for one transaction can be applied to other transactions.

The "lemons problem" is overcome in the used car market by

the existence of used car dealers who are concerned about maintaining their reputations.

Acme Widget tells investors it wants to build a new widget factory and sell investors $10,000,000 in bonds to finance it. Once they have raised the $10,000,000 the owners of Acme Widget use the funds to finance a trip to Atlantic City to try out a new scheme they have devised to win at blackjack. This is an example of

the moral hazard problem in financial markets.

Lenders prefer to lend to firms with high net worth because

the owners of such firms have more to lose if the firm defaults on a loan.

Economies of scale

the reduction in costs per unit that accompanies an increase in volume.

If there were no adverse selection problems in the stock market,

the willingness of savers to invest in the market would be increased.

When managers do not own very much of the net worth of the firm, then

there may be a principal-agent problem.

Why were financial intermediaries made?

to reduce transactions costs for small savers and borrowers.

When information costs of securities are very high, they lack

transparency.

You own a 2007 Ford Explorer. Although it has high mileage, you have maintained it very well. You want to sell it, but after checking the prices other owners of 2007 Ford Explorers are able to get for their cars in the used car market, you decide the prices are too low and you decide not to sell. This is an example of

"the lemons problem"

Small savers face

-high transactions costs in financial markets. -low transactions costs in financial intermediaries.

The presence of transactions costs and information costs

-raises the cost of funds to borrowers. -lowers the expected return to lenders.

Which of the following is an example of adverse selection?

A man with a bad heart condition buys a large life insurance policy.

Which of the following is NOT an example of adverse selection?

A) A family with a home ten feet from a large river buys flood insurance. B) A company uses the proceeds of a new stock sale to build an unnecessarily luxurious new headquarters. C) A terminal cancer patient buys life insurance. D) A company in serious financial trouble offers to pay you 30% on a loan. Answer: B

Which of the following is NOT an example of transactions costs?

A) High interest rates B) Lawyers' fees C) Brokerage commissions D) Minimum investment requirements Answer: A

Which of the following is NOT true of moral hazard?

A) It would not exist in a world of perfect information. B) It arises because borrowers typically know more than lenders. C) It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants. D) It describes a lender's problem in verifying borrowers are using their funds as intended. Answer: C

Which of the following is NOT true of adverse selection?

A) It would not exist in a world of perfect information. B) It arises because borrowers typically know more than lenders. C) It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants. D) It describes a lender's problem in verifying borrowers are using their funds as intended. Answer: D

Which of the following is NOT a company that collects information on individual borrowers and sells it to savers?

A) Moody's Investor Service B) Value Line C) NASDAQ D) Dun and Bradstreet Answer: C

Which of the following is NOT true of restrictive covenants?

A) They sometimes require borrowers to maintain the value of collateral offered to the lender. B) They increase the marketability and liquidity of loans. C) They sometimes require a borrower to maintain a certain minimum level of net worth. D) They sometimes limit a borrower's risk taking. Answer: B

One reaction of firms to the adverse selection problem is to

rely on internal funds to finance investment.

Moral hazard arises from

savers' difficulties in monitoring borrowers.

Which economist is credited with having been the first to discuss the "lemons problem"?

George Akerlof

A firm's principals are its

shareholders.

It is generally agreed that

small- and medium-sized firms benefit by the actions of intermediaries.

Why is adverse selection more likely in financial markets when interest rates rise?

The remaining borrowers are more likely to be risky.

Banks earn a profit by

charging savers and borrowers fees for reducing transactions costs.

The free-rider problem faced by private information-collection firms results in their

collecting less than all the available information about the firms they investigate.

Individual investors can reduce transactions costs by

combining their purchases through an intermediary.

Transaction and information costs

create profit opportunities for those who can reduce these costs.

In the United States the stake of top management in firms' ownership usually is

less than 5%.

The use of collateral

makes it more costly for borrowers to take advantage of their asymmetric information.

A firm's agents are its

management.

Symmetric information

means that savers and borrowers have the same information.

The purpose of collateral and restrictive covenants is to reduce ___ in debt contracts.

moral hazard

Why are corporations more likely to raise funds externally by debt instead of equity?

moral hazard is less of a problem with debt contracts

With debt financing

moral hazard problems are reduced but not eliminated.

In the late 2000s, which of the following was the primary source of external financing for small to medium-size firms?

mortgages

principal agent problem

occurs when one person or entity (the "agent") is able to make decisions on behalf of, or that impact, another person or entity: the "principal".

Moody's Investors Service is able to make a profit because

of the existence of adverse selection problems.

Financial intermediaries are able to act as delegated monitors for individual savers because

other investors are unable to gain a free ride on their monitoring efforts.

Generally, when there is asymmetric information

practical solutions are devised to allow lending to take place.

Restrictive covenants

put restrictions on the use of borrowed funds.

One method that lenders use to mitigate the adverse selection problem is to

ration credit.