ch 8

For this​ problem, use the fact that the expected value of an event is a probability weighted​ average, the sum of each probable outcome multiplied by the probability of the event occurring. You are in the market for a used car. At a used car​ lot, you know that the blue book value for the cars you are looking at is between ​$10,000 and ​$13,000. If you believe the dealer knows more about the cars than​ you, how much are you willing to​ pay? Assume that you care only about the expected value of the car you buy and that the car values are symmetrically distributed.

$10000 Yes, you can obtain more information about the car that you would like to buy

The current structure of financial markets can be best understood as the result of attempts by financial market participants to

. reduce transaction costs

Of the sources of external funds for nonfinancial businesses in the United​ States, stocks account for approximately​ ________ of the total.

11%

Of the sources of external funds for nonfinancial businesses in the United​ States, corporate bonds and commercial paper account for approximately​ ________ of the total

32%

Of the sources of external funds for nonfinancial businesses in the United​ States, loans from banks and other financial intermediaries account for approximately​ ________ of the total.

56%

Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a​ mortgage, he found that banks usually required collateral for up to​ 300% of the amount of the loan. Why might banks require that much collateral in a financial system like​ Gustavo's country?

An inefficient legal system implies weak property​ rights, and collateral helps banks recoup some of their loan if the borrower defaults less investment and slower economic growth

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States is​ true?

Bonds are a far more important source of financing than are stocks

Which of the following correctly lists a procedure used to reduce asymmetric information problems as well as the type of asymmetric information problem it​ reduces? Which of the following is true about techniques used to reduce asymmetric information​ problems?

Covenants are used to reduce moral hazard. Screening is used before the​ transaction; monitoring is used after the transaction.

Many policymakers in developing countries have proposed implementing systems of deposit insurance like the one that exists in the United States.​ However, replicating the financial system from one nation may not be successful in other nations due to different​ economies, politics,​ histories, etc

Deposit insurance is designed to decrease fears of bank runs and therefore increase confidence in banks and deposits. ​However, because depositors may feel that the​ "safety net" of deposit insurance means they no longer need to supervise banks​ themselves, asymmetric information in the form of moral hazard may increase .

How can economies of scale help explain the existence of financial intermediaries?

Financial intermediaries are able to operate with lower transaction costs relative to individual lenders or borrowers

What might lead to poor management when control and ownership are​ separate, like in many American​ corporations? What is the reason for this​ problem?

Principal-agent problem. A manager does not have sufficient incentive to maximize the​ company's profits.

Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their​ activities?

Sole​ proprietorships, partnerships, and small corporations

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are​ true?

Stocks and​ bonds, combined, supply less than one−half of the external funds.

How can the existence of asymmetric information provide a rationale for government regulation of financial​ markets?

The production of information to combat these asymmetries is subject to the​ free-rider problem

For this​ problem, use the fact that the expected value of an event is a probability weighted​ average, the sum of each probable outcome multiplied by the probability of the event occurring. You own a house worth ​$600,000 that is located on a river. If the river floods​ moderately, the house will be completely destroyed. This happens about once every 20 years. If you build a​ seawall, the river would have to flood heavily to destroy your​ house, which only happens about once every 200 years. What would be the annual premium without a seawall for an insurance policy that offers full​ insurance?

Without a​ seawall, the annual premium is ​$30,000. ​(Round your response to the nearest whole​ number.) What would be the annual premium with a seawall for an insurance policy that offers full​ insurance? With a​ seawall, the annual premium is ​$3000. ​(Round your response to the nearest whole​ number.) For a policy that only pays 8080​% of the home​ value, what are your expected costs without a​ seawall? Without a​ seawall, the expected cost is ​$30,000. ​(Round your response to the nearest whole​ number.) For a policy that only pays 8080​% of the home​ value, what are your expected costs with a​ seawall? With a​ seawall, the expected cost is ​$3000. ​(Round your response to the nearest whole​ number.) Do the different policies provide an incentive to be safer​ (i.e., to build the​ seawall)? A. Neither insurance policy is better or worse because the expected costs each year are the same under both scenarios.

Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done​ so?

You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard

The problem created by asymmetric information before the transaction occurs is called​ ________, while the problem created after the transaction occurs is called​ ________.

adverse​ selection; moral hazard

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 stockholderminus−owners do.

agents; principals

The​ 'lemons problem' in used car markets​ causes

all​ high-quality vehicles to be driven out of the market

Debt contracts

are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.

The​ "lemons problem" exists because of

asymmetric information.

The structure of financial markets is the result​ of:

attempting to reduce transaction costs.

Although restrictive covenants can potentially reduce moral​ hazard, a problem with restrictive covenants is that

borrowers may find loopholes that make the covenants ineffective

The predominant form of household debt is

collateralized debt.

Bonds account for a larger fraction of external funds relative to equities raised by American businesses​ because:

costly state verification makes the equity contract less desirable than the debt contract

The name economists give the process by which stockholders gather information by frequent monitoring of the​ firm's activities is

costly state verification.

As information technology​ improves, the lending role of financial institutions such as banks should​ ________.

decrease

Regulation of the financial system

ensures the stability of the financial system.

Financial intermediaries develop​ ________ in things such as computer technology which allows them to lower transactions costs

expertise

Which of the following is not a benefit to an individual purchasing a mutual​ fund?

free-riding

Nonfinancial businesses in​ Germany, Japan, and Canada raise most of their funds

from bank loans.

Analysis of adverse selection indicates that financial​ intermediaries, especially​ banks,

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

A debt contract is incentive compatible

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.

Government regulations designed to reduce the moral hazard problem include

laws that force firms to adhere to standard accounting principles.

For restrictive covenants to help reduce the moral hazard problem they must be​ ________ by the lender.

monitored and enforced

The problem faced by the lender that the borrower may take on additional risk after receiving the loan is called

moral hazard

Problems created by asymmetric information after the transaction occurs is called​ ________, while the problem created before a transaction occurs is called​ ________.

moral​ hazard; adverse selection

A problem for equity contracts is a particular type of​ ________ called the​ ________ problem.

moral​ hazard; principal−agent

One way the venture capital firm avoids the free−rider problem is by

prohibiting the sale of equity in the firm to anyone except the venture capital firm

The free rider​ problem:

results from the production of information being much like a public good where exclusion is not possible

Collateralized debt is also know as

secured debt.

Of the following sources of external finance for American nonfinancial​ businesses, the least important is

stocks

Government regulations require publicly traded firms to provide​ information, reducing

the adverse selection problem

One reason financial systems in developing and transition countries are underdeveloped is

the legal system may be poor making it difficult to enforce restrictive covenants.

Adverse selection is a problem associated with equity and debt contracts arising from

the​ lender's relative lack of information about the​ borrower's potential returns and risks of his investment activities.

Credit card debt is

unsecured debt.

An institution in our financial structure that helps reduce the moral hazard arising from the​ principal-agent problem is​ the:

venture capital firm.

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal−agent problem is the

venture capital firm.

The concept of adverse selection helps to explain

why financial markets are among the most heavily regulated sectors of the economy.

Asymmetric information 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

​principal-agent