econ ch 9

what are free riders?

individuals who gain access to the information collected on a firm without paying for it

•Small investors and small- to medium-sized firms turn to financial ____________________ to meet their financial needs. •Those individuals and firms face transaction costs and information costs.

intermediaries

the financial system channels funds from savers to ______________

investors

•Firms must disclose ________________- ___________________, which is information that, if known, would likely affect the price of a firm's stock.

material information

do crowdfunding sites reduce the principal-agent problem?

no

· Loans are the primary source of funds for small-to-medium-sized firms, while the bond market is the _______________ source of funds for large corporations.

primary

Relationship banking

the ability of banks to assess credit risks on the basis of private information about borrowers

transaction cost

the cost of a trade or a financial transaction

information cost

the cost that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired

adverse selection example pt 1 safe firm: firms must sell bond to finance project that costs $100 -the project earns $125 for certain risky firm: firms must sell bond to finance project that costs $100 -project earns $150 with 2/3 probability, and $0 with 1/3 probability -firm defaults on bond if $0 earnings. -expected payment on bond is thus 2/3 of the promised payment savers: will buy bonds for $100 if expected payment is least __________

$110

•If 90% of the firms in the stock market are good firms and 10% are lemons, and the good firm's share of stock is $50, then: Expected value=(0.90×$50)+(0.10×$5)=$45.50 •So, you would be willing to pay ____________ for a share of stock, but to a good firm this is below the fundamental value of the stock.

$45.50

An article in the Economist magazine​ observes: ​"Insurance companies often suspect the only people who buy insurance are the ones most likely to​ collect." ​Source:​ "The Money​ Talks," Economist​, December​ 5, 2008. What do economists call the problem being described​ here? A. Adverse selection. B. ​Principal-agent problem. C. Moral hazard. D. All of the above. If insurance companies are correct in their​ suspicion, it will _____________ the price of insurance.

a. Adverse selection. increase

Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically​ optimal? A. Asymmetric information makes information costs for external funds higher than for internal​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal. B. Asymmetric information makes information costs for internal funds higher than for external​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal. C. Asymmetric information makes information costs for external funds higher than for internal​ funds, and these costs necessarily imply that firms are able to spend less on expansion than is economically optimal. D. The information problems have to do with the inability of borrowers to directly link up with savers​ which, as a​ consequence, causes firms to spend less on expansion than is economically optimal.

a. Asymmetric information makes information costs for external funds higher than for internal​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal.

Why did corporate net worth decline by so much during the recession of 2007-​2009? A. Corporate net worth declined significantly during the 2007-2009 recession because corporations lost revenue due to a large decline in household net worth and spending. B. Corporate net worth declined significantly during the 2007-2009 recession because​ corporations' assets and liabilities increased significantly. C. Corporate net worth declined significantly during the 2007-2009 recession because​ corporations' liabilities decreased significantly. D. Corporate net worth declined significantly during the 2007-2009 recession because​ corporations' liabilities increased significantly.

a. Corporate net worth declined significantly during the 2007-2009 recession because corporations lost revenue due to a large decline in household net worth and spending.

How might the decline in corporate net worth have affected the severity of the 2007-2009 ​recession? A. It exacerbated the severity of the 2007-2009 recession. B. The decline in corporate​ net-worth in the​ non-financial services sector did not affect the severity of the recession because the recession was caused primarily due to failings of the financial services sector. C. It alleviated the severity of the 2007-2009 recession. D. None of the above.

a. It exacerbated the severity of the 2007-2009 recession.

What effect has the SEC had on the level of asymmetric information in the U.S. financial​ system? A. The SEC has been successful in reducing the cost of asymmetric​ information, but it has not eliminated it completely. B. The SEC has been successful in completely eliminating the cost of asymmetric information. C. The SEC has not been successful in eliminating the cost of asymmetric information at all. D. After the SEC was​ founded, the level of asymmetric information in the U.S. financial system increased tremendously.

a. The SEC has been successful in reducing the cost of asymmetric​ information, but it has not eliminated it completely.

What is corporate net​ worth? A. Assets minus liabilities. B. The amount left after dividends are paid minus​ short-term debt. C. The amount left after dividends are paid. D. Retained earnings minus its long term debt.

a. assets minus liabilities

adverse selection example pt 3 (with asymmetric info) savers: if both firms issue bonds, the average probability of payment is 5/6 (average of 1 and 2/3) -savers require promised payment of $132 to get an expected payment of $110 (5/6*132=110) safe firm: $132 exceeds earnings of $125 so the firms ____________ the project and no bond is issued risky firm: will issue bond -has 2/3 chance of earning $150 for profit of $18 (150-132=18) -savers require promised payment of $165 though because the probability of pyament is 2/3 and thus, ____ bond is issued

abandons, no

moral hazard is an outcome of ____________________ information

asymmetric

A column in the Wall Street Journal offered the opinion that​ "as a rule of​ thumb, the more complex a​ [financial] product​ is, the worse the​ deal." Do you​ agree? Why would a more complex financial product be likely to be a worse deal for an investor than a simpler​ product? A. Agree. The more complex the​ product, the easier it is for an investor to assess the risk of the product. B. Agree. When investors buy simpler​ products, they typically have more information and can make more informed choices about the products. C. Agree. The more complex deal is often one for which information costs​ decrease, which reduces the resulting return on the investment. D. Disagree. A more complex financial product is likely to be guaranteed by its issuer.

b. Agree. When investors buy simpler​ products, they typically have more information and can make more informed choices about the products.

Why would banks make bad commercial real estate​ loans? Don't banks lose money if these loans​ default? A. Banks never make bad​ loans; loans only become bad when unforeseen shocks to the economy​ occur, and banks do incur losses in these cases. B. Banks might make bad loans if potential losses on the loans are borne by entities other than the banks. C. Banks often make bad loans because they are required by government to lend money to​ sub-prime borrowers, and they suffer losses​ that, in​ turn, require government bailouts. D. Banks might make bad loans if they do a poor job of assessing the creditworthiness of​ borrowers, but they nevertheless do not incur losses because of tax write offs.

b. Banks might make bad loans if potential losses on the loans are borne by entities other than the banks.

Why would investors buy securities that contain bad commercial real estate​ loans? A. Inaccurate rating agency judgements may cause investors to buy securities containing bad loans. B. Investors might buy securities containing bad loans if they are risk​ "enthusiasts." C. Investors might buy securities containing bad loans if securities are misrepresented. D. All of the above. E. Only A and C are plausible.

e. only a and c are plausible

venture capital firm raises...

equity capital from investors to invest in start-up firms

A private equity firm (or corporate restructuring firm) raises...

equity capital to acquire shares in other firms to reduce free-rider and moral hazard problems.

· Financial intermediaries are continually searching for ways to earn a profit by _________________ the flow of funds from savers to borrowers.

expediting

The organization of large, publicly traded corporation's results in a _____________________ ____ _________________ _________ __________________

separation of ownership from control

•Firms are owned by ____________________ but run by top management (CEO, CFO, COO, etc.)

shareholders

The principal-agent problem

the moral hazard problem of managers (the agents) pursuing their own interests rather than those of shareholders (the principals)

· Moral hazard

the problem investors experience in verifying that borrowers are using their funds as intended

what is economies of scale?

the reduction in average cost that results from an increase in the volume of a good or service produced

credit rationing

the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate

what is moral hazard?

the risk that people will take actions after they have entered into a transaction that will make the other party worse off

asymmetric information

the situation in which one party to an economic transaction has better information than does the other party

between bond markets and stock markets, which has less moral hazard?

there is less moral hazard in the bond market

how do financial intermediaries reduce transaction costs?

they take advantage of economies of scale to reduce transaction and informational costs

moral hazard in the stock market •Managers have an incentive to _______________________ profits so that they can reduce dividends and retain the use of the funds. •To reduce this problem, the SEC requires managers to _____________ financial statements. •Boards of directors meet infrequently and may not be independent of top managers. •Some boards of directors use _______________ contracts to align the goals of managers with the goals of shareholders. •Compensation tied to the firm's profits, however, may lead managers to undertake _________ investments.

underreport, issue, incentive, risky

The Numerical Example for Moral Hazard •Assume a single firm can invest in a safe project with a certain return of $125 or a risky project with a return of $150 and a probability of success of 2/3. •Both projects cost $100 and can be financed by selling a $100 bond paying $10 interest. •The profit for the safe project is $15 (= $125 - $110). •The expected profit for the risky project is $26.27 (=2/3($150 - $110)). •Savers know that firms will choose the more profitable risky project and _____________ buy bonds, so the market unravels.

won't

2 problems asymmetric information leads to in financial markets:

1. adverse selection 2. moral hazard

Net worth is the difference between the value of a firm's _____________ and the value of its _________________ .

assets, liabilities

Which of the following are examples of a nonfinancial​ corporation? ​(Check all that apply​) A. Berkshire Hathaway B. Fidelity C. Chase D. Apple E. Goldman Sachs

a and d

restrictive covenant

a clause in a bond contract that places limits on the uses of funds that a borrower receives

To deal with firms' information advantage, lenders often require borrowers to have ____________ and high net _____________

collateral, worth

Regulations, collateral, and financial intermediaries help to ____________ adverse selection, but do not eliminate it

reduce

what is adverse selection? e.g. •The seller of a used car has more information on the true condition of a car than does a potential buyer. •The prices that potential buyers are willing to pay reflect the buyers' lack of complete information on the true condition of the car. •Because of asymmetric information, the used car market adversely selects the cars that will be offered for sale. Expected value = (probability that car is good) * (value if good) + (probability the car is a lemon) * (value if lemon)

the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment

· Adverse selection

the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment

is adverse selection present in the bond market?

yes

•Disclosure of information to the SEC reduces the information costs of adverse selection, but it doesn't eliminate them for a few reasons:

1.Some good firms may be too young to have much information for potential investors to evaluate. 2.Lemon firms will try to present the information in the best possible light so that investors will overvalue their securities. 3.There can be legitimate differences of opinion about how to report some items on income statements and balance sheets. Interpretation of whether information is material can be tricky.

Which of the following is true regarding the Securities and Exchange Commission​ (SEC)? A. The​ SEC's primary role is to increase adverse selection by requiring the disclosure of financial and accounting information from all publicly traded firms. B. The SEC is a federal government agency that regulates U.S. stock and bond markets. C. The​ SEC's primary role is to reduce moral hazard by requiring the disclosure of financial and accounting information from all publicly traded firms. D. Both B and C are correct.

b. The SEC is a federal government agency that regulates U.S. stock and bond markets.

Economist Richard Sylla of New York University has argued that in the​ 1790s, Secretary of the Treasury Alexander Hamilton "established the financial foundations that would make the United States the most successful emerging market in the nineteenth​ century, and the economic colossus of the next that some would call the​ 'American ​century.'" ​Source: Richard​ Sylla, "Financial ​Foundations: Public​ Credit, the National​ Bank, and Securities ​Markets," in Douglas A. Irwin and Richard​ Sylla, eds., Founding​ Choices: American Economic Policy in the 1790s​, ​Chicago: University of Chicago​ Press, 2011, p. 86. Sylla would focus on all of the following "financial foundations" of the United​ States, except: A. The creation of stock and bond markets. B. The issuance of currency. C. Investor confidence in the credit of the United States. D. The establishment of a central bank. All of the following are reasons why these financial foundations were important in making possible the rapid growth of the U.S. economy during the nineteenth and twentieth​ centuries, except: A. A central bank provided direct control over all interest​ rates, facilitating the control and direction of the overall economy. B. Once financial markets were​ organized, they provided corporations with a way to raise funds and investors with a way to participate in the growth of the economy. C. The financial system provided a way for funds to flow from savers to entrepreneurs establishing and expanding new businesses. D. A central bank made loans more widely available to businesses and inspired state governments to allow other private banks to be established.

b. The issuance of currency. a. A central bank provided direct control over all interest​ rates, facilitating the control and direction of the overall economy.

The SEC was founded A. in 1929 in order to regenerate the market. B. in 1934 in an attempt to alleviate the asymmetric information problem that became apparent following the stock market crash of 1929. C. after the​ "Dotcom collapse" in an attempt to alleviate the asymmetric information problem. D. in 1935 in order to regulate the derivative market.

b. in 1934 in an attempt to alleviate the asymmetric information problem that became apparent following the stock market crash of 1929.

•Securitization involves...

bundling loans, such as mortgages, into securities that can be sold in financial markets

adverse selection example pt 2 (with symmetric info) Safe firm: sells bond that pays $110 -earns profit of $125-$110=$115 -thus, savers ________ the bond risky firm: savers require promised payment of $165 to get expected payment of $110 (2/3*165=110) -$165 exceeds highest possible earnings (which is $150) so the firm abandons the project and ______ bond is issued

buy, no

Consider the possibility of income insurance. With income​ insurance, if a person loses his job or​ doesn't get as big a raise as​ anticipated, he would be compensated under his insurance coverage. Why​ don't insurance companies offer income insurance of this​ type? ​(Check all that​ apply.) A. The problem is adverse selection​ (once insured, you​ won't work as​ hard). B. The problem is moral hazard​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). C. The problem is adverse selection​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). D. The problem is moral hazard​ (once insured, you​ won't work as​ hard). E. This type of insurance would be unpopular among workers.

c and d

Why are financial intermediaries important to the financial​ system? A. Without them firms would not have access to capital. B. They offer a level of insurance to small​ investors, guaranteeing their investments. C. They reduce transaction and information costs that often drive a wedge between savers and borrowers. D. They facilitate direct access between savers and borrowers.

c. They reduce transaction and information costs that often drive a wedge between savers and borrowers.

The World Bank measures financial development​ by: A. the total amount of outstanding debt. B. the total amount of savings in household and business accounts. C. the total amount of credit banks and financial markets extend to households and firms as a percentage of GDP. D. the number of banks and financial institutions. The World​ Bank's data tells us that countries with higher levels of financial development tend to have _____________ levels of real GDP per​ capita, which indicates they are _____________ able to provide a high standard of living for their residents.

c. the total amount of credit banks and financial markets extend to households and firms as a percentage of GDP higher, better

moral hazard in the bond market: •To reduce moral hazard in bond markets, investors insert restrictive ______________________ into bond contracts.

covenants

What is​ securitization? A. The practice of​ "securing" payments from borrowers by requiring a pledge of collateral. B. The process of converting securities that are not tradable into securities that are tradable. C. The practice of insuring assets against default loss. D. The process of converting loans and other financial assets that are not tradable into securities.

d. The process of converting loans and other financial assets that are not tradable into securities.

Is it likely that the interest rates on these securities were high enough to compensate investors for the additional risk involved with these​ securities? Briefly explain. A.It is not likely that the interest rates on these securities were high enough given the financial meltdown that​ ensued; hindsight​ is, of​ course, 20-20. B.The interest rates would have been high enough to compensate investors for the additional risk if the rating agencies had accurately assessed the​ risks; unfortunately, the agencies underperformed. C.The interest rates were​ "spot on" given the risks involved. Investors just got too greedy. D.A and B are correct.

d. a and b are correct

What is the most important method of debt financing for​ corporations? A. Trade credit. B. The stock market. C. Banks loans​ (other than​ mortgages). D. The bond market.

d. the bond market

lateral includes assets that a borrower pledges to a lender that the lender may seize if the borrower _____________ on the loan.

defaults

when lenders ration credit, ALL firms (good or lemons) may have some _________________ borrowing funds

difficulty

Countries with higher levels of financial development tend to have _______________ levels of real GDP per capita.

higher

•By reducing transactions and information costs, financial intermediaries can offer ______________ interest rates for savers and ____________ interest rates for borrowers.

higher, lower

difference between indirect and direct finance

in indirect finance, funds flow through financial institutions whereas in direct finance, funds flow directly from savers to investors in the securities market

•The increase in securitization may have led to an ________________ in adverse selection by changing banks' focus of relationship banking to the originate-to-distribute business model—banks sell loans to others rather than holding them to maturity. •Securitization and the originate-to-distribute model increased adverse selection problems by reducing banks' incentive to distinguish between good borrowers and lemon borrowers.

increase

Decades​ ago, many bank records were written by hand in ledgers. At the​ time, banks achieved _____________ economies of scale as the amount of labor required to maintain such records was _____ ______ for every​ transaction, _____________ of the size of the bank. The shift to keeping all records on computers has _________________ the opportunities to achieve economies of scale by replacing __________ costs with _____________________ costs.

little, the same, regardless, increased, labor, technology

What is the difference between venture capital firms and private equity​ firms? A _______________ equity firm raises equity capital to acquire shares in established firms with the intention of reducing ____________ ____________ problems. A ______________ capital firm is a firm that raises equity capital from investors to invest in startup firms

private, moral hazard, venture

In Your Interest Is It Safe to Invest Through Crowdfunding Sites? •Crowdfunding sites act as financial intermediaries that reduce transactions costs for investors. •There is no clear evidence that crowdfunding sites ___________ information asymmetries. •Crowdfunding sites do not invest in the startups themselves and so do not reduce the principal-agent problem.

reduce

collateral and net worth ________ adverse selection problems. as do financial intermediaries

reduce

· Corporate boards of directors, incentive contracts, and financial intermediaries help to ______________, but not eliminate, moral hazard.

reduce

•Private firms have collected and sold information about firms to investors to _____________ adverse selection costs.

reduce

Relationship banking ___________ the costs of adverse selection and explains the key role banks play in providing external financing to firms.

reduces

•A market for corporate control provides a means to ______________ top management that is failing to carry out the wishes of shareholders.

remove

•As interest rates on bonds _______, a larger fraction of the firms willing to pay the high interest rates are lemon firms.

rise

· Developing a strong financial system can be essential to providing a foundation for robust economic growth and a _____________ standard of living.

rising

3 key features of the financial system: 1. loans from financial intermediaries are the MOST important external source of funds for small-to-medium size firms •Smaller firms cannot borrow directly from savers because transactions costs are too high. •They cannot sell bonds or stocks because of the adverse selection and moral hazard problems that arise from asymmetric information. 2. The stock market is a less important source of external funds to corporations than is the bond market. •Most of the trading on the stock market involves existing shares, not new shares of stock. •In recent years, corporations have actually bought back from investors more stock than they have issued. •Moral hazard is less of a problem with debt contracts than with equity contracts. 3. Debt contracts usually require collateral or restrictive covenants. •Large household loans use the good being purchased as collateral. •Many corporate bonds also specify collateral. •To reduce moral hazard, both loans and bonds typically contain restrictive covenants.

yep

A Numerical Example - Assumptions •Two firms have investment projects costing $100 each. •One firm has a safe project that produces $125 of revenue in one year. •The other firm has a risky project producing $150 of revenue with a probability of 2/3 and producing nothing with a probability of 1/3. •Each firm must sell a bond for $100 to fund its project. •Savers can buy an asset with a 10% yield, paying $110 in one year. •A bond must have an equal expected payment: expected payment from bond = promised payment × probability of project success. (symmetric info)•Savers know the risk of each project and associated bond. •The safe firm can sell a bond promising $110 and have a profit of $15 ($125 - $110 = $15). •The risky firm's bond has an expected return of $100 ($150 × 2/3 = $100). •To promise $110, the project must return $165 ($165 × 2/3 = $110). However, $165 > $150, so the risky firm cannot sell the bond. (asymmetric info)•Savers do not know which firm is risky. •Savers view each firm's bond as having a probability of success of 5/6 ((1 + 2/3)/2=5/6). •Bonds must promise payment of $132 to have an expected payment of $110 ($132 × 5/6= 110). •The adverse selection problem: •The safe firm will not issue bonds promising $132 since its project returns $125. •The risky firm will issue bonds since it profits $18 (= $150 - $132) if the project succeeds and defaults if the project fails. •Savers realize that all bonds are risky and the true probability of success is 2/3, requiring that bonds promise $165 to have an expected return of $110. •Neither firm issues bonds.

yep

Corporations Are Issuing More Bonds, but Should You Buy Them? •As interest rates on U.S. Treasury bonds declined to record low levels, demand for corporate bonds increased, driving down their yields as well. •The declining yields on corporate bonds resulted in a very small default risk premium over the Treasury bonds while the corporations' default risk did not change. •The record low yields on long-term corporate bonds were also subject to significant interest-rate risk in the future.

yep

How Financial Intermediaries Reduce Moral Hazard Problems

•Financial intermediaries have evolved to fill the gap left by the ban on banks making equity investments in nonfinancial firms.

•factors that determine a country's standard of living include:

•The ability of businesses to accumulate physical capital •The ability of businesses to adopt the latest technology •The ability of the government to provide a legal framework that protects property rights and enforce contracts