Money and Banking Ch 8

A debt contract is incentive compatible A) if the borrower has the incentive to behave in the way that the lender expects and desires, since doing otherwise jeopardizes the borrower's net worth in the business. B) if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced. C) if the debt contract is treated like an equity. D) if the lender has the incentive to behave in the way that the borrower expects and desires.

A

Although debt contracts require less monitoring than equity contracts, debt contracts are still subject to ________ since borrowers have an incentive to take on more risk than the lender would like. A) moral hazard B) agency theory C) diversification D) the "lemons" problem

A

Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that A) borrowers may find loopholes that make the covenants ineffective. B) they are inexpensive to monitor and enforce. C) too many resources may be devoted to monitoring and enforcing them, as debtholders duplicate others' monitoring and enforcement efforts. D) they reduce the value of the debt contract.

A

An example of the ________ problem would be if Brian borrowed money from Sean in order to purchase a used car and instead took a trip to Atlantic City using those funds. A) moral hazard B) adverse selection C) costly state verification D) agency

A

Analysis of adverse selection indicates that financial intermediaries, especially banks A) have advantages in overcoming the free-rider problem, helping to explain why indirect finance is a more important source of business finance than is direct finance. B) despite their success in overcoming free-rider problems, nevertheless play a minor role in moving funds to corporations. C) provide better-known and larger corporations a higher percentage of their external funds than they do to newer and smaller corporations which rely to a greater extent on the new issues market for funds. D) must buy securities from corporations to diversify the risk that results from holding non-tradable loans.

A

Because of the weak systems of property rights in many developing and transition economies, the financial system is unable to use collateral effectively worsening the ________ problem. A) adverse selection B) moral hazard C) principal/agent D) diversification

A

Debt contracts A) are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals. B) have a higher cost of state verification than equity contracts. C) are used less frequently to raise capital than are equity contracts. D) never result in a loss for the lender.

A

Direct finance involves the sale to ________ of marketable securities such as stocks and bonds. A) households B) insurance companies C) pension funds D) financial intermediaries

A

Equity contracts A) are claims to a share in the profits and assets of a business. B) have the advantage over debt contracts of a lower costly state verification. C) are used much more frequently to raise capital than are debt contracts. D) are not subject to the moral hazard problem.

A

Equity contracts account for a small fraction of external funds raised by American businesses because A) costly state verification makes the equity contract less desirable than the debt contract. B) of the reduced scope for moral hazard problems under equity contracts, as compared to debt contracts. C) equity contracts do not permit borrowing firms to raise additional funds by issuing debt. D) there is no moral hazard problem when using a debt contract.

A

Financial intermediaries' low transaction costs allow them to provide ________ services that make it easier for customers to conduct transactions. A) liquidity B) conduction C) transcendental D) equitable

A

For restrictive covenants to help reduce the moral hazard problem, they must be ________ by the lender. A) monitored and enforced B) written in all capitals C) easily changed D) impossible to remove

A

Government regulations designed to reduce the moral hazard problem include A) laws that force firms to adhere to standard accounting principles. B) light sentences for those who commit the fraud of hiding and stealing profits. C) state verification subsidies. D) state licensing restrictions.

A

If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of A) moral hazard. B) adverse selection. C) free-riding. D) costly state verification.

A

In developing countries, it can be expensive and time-consuming for the poor to legalize their property ownership. Without legal title, the property cannot be used as ________ to borrow funds. A) collateral B) points C) interest D) restrictive covenants

A

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer. A) principal-agent B) adverse selection C) free-rider D) debt deflation

A

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the A) venture capital firm. B) money market mutual fund. C) pawn broker. D) savings and loan association.

A

One possible reason for slower growth in developing and transition countries is A) capital may not be directed to its most productive use. B) strict accounting standards are too stringent for the banks to meet. C) the weak link between government and financial intermediaries. D) the lack of adverse selection and moral hazard problems.

A

Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called A) collateral. B) points. C) interest. D) good faith money.

A

Since they require less monitoring of firms, ________ contracts are used more frequently than ________ contracts to raise capital. A) debt; equity B) equity; debt C) debt; loan D) equity; stock

A

That only large, well-established corporations have access to securities markets A) explains why indirect finance is such an important source of external funds for businesses. B) can be explained by the problem of moral hazard. C) can be explained by government regulations that prohibit small firms from acquiring funds in securities markets. D) explains why newer and smaller corporations rely so heavily on the new issues market for funds.

A

The ________ problem helps to explain why the private production and sale of information cannot eliminate ________. A) free-rider; adverse selection B) free-rider; moral hazard C) principal-agent; adverse selection D) principal-agent; moral hazard

A

The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________. A) adverse selection; moral hazard B) moral hazard; adverse selection C) costly state verification; free-riding D) free-riding; costly state verification

A

Tools to help solve the adverse selection problem in financial markets include all of the following EXCEPT A) diversification. B) government regulations to increase information. C) the use of financial intermediaries. D) the private production and sale of information.

A

A problem for equity contracts is a particular type of ________ called the ________ problem. A) adverse selection; principal-agent B) moral hazard; principal-agent C) adverse selection; free-rider D) moral hazard; free-rider

B

Because information is scarce A) helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts. B) monitoring managers gives rise to costly state verification. C) government regulations, such as standard accounting principles, have no impact on problems such as moral hazard. D) developing nations do not rely heavily on banks for business financing.

B

If you default on your auto loan, your car will be repossessed because it has been pledged as ________ for the loan. A) interest B) collateral C) dividend D) commodity

B

Of the following sources of external finance for American nonfinancial businesses, the least important is A) loans from banks. B) stocks. C) bonds and commercial paper. D) loans from other financial intermediaries.

B

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it A) collateralizes the debt contract. B) makes the debt contract incentive compatible. C) state verifies the debt contract. D) removes all of the risk in the debt contract.

B

Solutions to the moral hazard problem include A) low net worth. B) monitoring and enforcement of restrictive covenants. C) greater reliance on equity contracts and less on debt contracts. D) greater reliance on debt contracts than financial intermediaries.

B

A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a A) collateral-insurance clause. B) prescription covenant. C) restrictive covenant. D) proscription covenant.

C

That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries A) have been afforded special government treatment, since used car dealers do not provide information that is valued by consumers of used cars. B) are able to prevent potential competitors from free-riding off the information that they provide. C) have failed to solve adverse selection problems in this market because "lemons" continue to be traded. D) have solved the moral hazard problem by providing valuable information to their customers.

B

The principal-agent problem would not occur if ________ of a firm had complete information about actions of the ________. A) owners; customers B) owners; managers C) managers; customers D) managers; owners

B

The problem faced by the lender that the borrower may take on additional risk after receiving the loan is called A) adverse selection. B) moral hazard. C) transactions costs. D) diversification.

B

The reduction in transactions costs per dollar of investment as the size of transactions increases is A) discounting. B) economies of scale. C) economies of trade. D) diversification.

B

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE? A) Stocks are a far more important source of finance than are bonds. B) Stocks and bonds, combined, supply less than one-half of the external funds. C) Financial intermediaries are the least important source of external funds for businesses. D) Since 1970, more than half of the new issues of stock have been sold to American households.

B

Because of the adverse selection problem A) good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks. B) lenders may refuse loans to individuals with high net worth, because of their greater proclivity to "skip town." C) lenders are reluctant to make loans that are not secured by collateral. D) lenders will write debt contracts that restrict certain activities of borrowers.

C

By bundling share purchases of many investors together mutual funds can take advantage of economies of scale and thereby lower A) adverse selection. B) moral hazard. C) transactions costs. D) diversification.

C

Government regulations require publicly traded firms to provide information, reducing A) transactions costs. B) the need for diversification. C) the adverse selection problem. D) economies of scale.

C

High net worth helps to diminish the problem of moral hazard problem by A) requiring the state to verify the debt contract. B) collateralizing the debt contract. C) making the debt contract incentive compatible. D) giving the debt contract characteristics of equity contracts.

C

One reason financial systems in developing and transition countries are underdeveloped is A) they have weak links to their governments. B) they make loans only to nonprofit entities. C) the legal system may be poor making it difficult to enforce restrictive covenants. D) the accounting standards are too stringent for the banks to meet.

C

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are A) limited-liability clauses. B) risk insurance. C) restrictive covenants. D) illegal.

C

The concept of adverse selection helps to explain A) why collateral is not a common feature of many debt contracts. B) why large, well-established corporations find it so difficult to borrow funds in securities markets. C) why financial markets are among the most heavily regulated sectors of the economy. D) why stocks are the most important source of external financing for businesses.

C

The concept of adverse selection helps to explain all of the following EXCEPT A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets. B) why indirect finance is more important than direct finance as a source of business finance. C) why direct finance is more important than indirect finance as a source of business finance. D) why the financial system is so heavily regulated.

C

The principal-agent problem A) occurs when managers have more incentive to maximize profits than the stockholders-owners do. B) in financial markets helps to explain why equity is a relatively important source of finance for American business. C) would not arise if the owners of the firm had complete information about the activities of the managers. D) explains why direct finance is more important than indirect finance as a source of business finance.

C

The problem of adverse selection helps to explain A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets. B) why collateral is an important feature of consumer, but not business, debt contracts. C) why direct finance is more important than indirect finance as a source of business finance. D) why lenders refuse loans to individuals with high net worth.

C

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE? A) Issuing marketable securities is the primary way that they finance their activities. B) Bonds are the least important source of external funds to finance their activities. C) Stocks are a relatively unimportant source of finance for their activities. D) Selling bonds directly to the American household is a major source of funding for American businesses.

C

A ________ is a provision that restricts or specifies certain activities that a borrower can engage in. A) residual claimant B) risk hedge C) restrictive barrier D) restrictive covenant

D

A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he plans to undertake than does the lender. This inequality of information is called A) moral hazard. B) asymmetric information. C) noncollateralized risk. D) adverse selection.

D

American businesses get their external funds primarily from A) bank loans. B) bonds and commercial paper issues. C) stock issues. D) loans from nonbank financial intermediaries.

D

Managers (________) may act in their own interest rather than in the interest of the stockholder-owners (________) because the managers have less incentive to maximize profits than the stockholder-owners do. A) principals; agents B) principals; principals C) agents; agents D) agents; principals

D

Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds A) by issuing stock. B) by issuing bonds. C) from nonbank loans. D) from bank loans.

D

Of the four sources of external funding for nonfinancial businesses, the least often used in the U.S. is A) bank loans. B) nonbank loans. C) bonds. D) stock.

D

Solutions to the moral hazard in equity contracts include all of the following EXCEPT A) government regulations to increase information. B) the use of financial intermediaries. C) the use of debt contracts. D) government ownership of resources.

D

The presence of ________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets. A) noncollateralized risk B) free-riding C) asymmetric information D) costly state verification

D

Explain the principal-agent problem as it pertains to equity contracts.

explain

Why does the free-rider problem occur in the debt market?

explain