Chapter 11 Questions

What problem associated with asymmetric information was central to Bernard Madoff's success in cheating so many investors for so long?

Bernard Madoff ran a Ponzi scheme. Investors lost money because Madoff wasn't investing their money like they had intended it to be invested. He knew more about what was going on than the investors that were giving him money. The investors didn't have all of the information and Madoff wasn't monitored properly, which was why he got away with cheating so many investors for so long. The problem associated with asymmetric information was a moral hazard problem.

Define the term economies of scale and explain how a financial intermediary can take advantage of such economies.

Economies of scale: when the average cost of producing a good or service falls as the quantity produced increases. Financial intermediaries can take advantage of economies of scale by using the same standardized forms for obtaining information from potential borrowers when they are in the process of determining whether they qualify for a loan.

The financial sector is heavily regulated. Explain how government regulations help to solve information problems, increasing the effectiveness of financial markets and institutions.

Government regulations help to solve information. They have requirements which tell certain firms that they have to provide the public with specific information. This gives investors access to financial information which helps them to make decisions. And when firms know that they have to make information public, they may be less likely to try to bend rules.

Suppose a new website was launched providing up-to-date, credible information on all firms wishing to issue bonds. What would you expect to happen to the overall level of interest rates in the bond market?

I predict that interest rates would fall with the release of up-to-date, credible information on all firms wishing to issue bonds because of increased consumer demand. This information would make it easier for investors to determine the creditworthiness of firms and demand should rise because of the ease and aid in decision-making. When demand rises, interest rates decline.

Suppose two types of firms wish to borrow in the bond market. Firms of type A are in good financial health and are relatively low risk. The appropriate premium over the risk-free rate of lending to these firms is 2 percent. Firms of type B are in poor financial health and are relatively high risk. The appropriate premium over the risk-free rate of lending to these firms is 6 percent. As an investor, you have no other information about these firms except that type A and type B firms exist in equal numbers. a. At what interest rate would you be willing to lend if the risk-free rate were 5 percent? b. Would this market function well? What type of asymmetric information problem does this example illustrate?

I would set interest rates at 7% for type A and 11% for type B. I calculated these by adding the risk-free rate (5%) to the appropriate premium over the risk-free rates for type A (2%) and type B (6%). If I were lending, I would use the average between the two, 9%, as the interest rate. This market would not function well because 9% is a high level of interest for type A and people probably wouldn't want to pay that must interest. This would leave type B firms, which are in poor financial health and relatively high risk. It wouldn't be good for the market to lose type A firms, which are in good financial health.

Consider again the low-risk type A firm described in Problem 15. If you were the financial advisor to such a firm, what suggestions would you make to the firm's management about obtaining borrowed funds?

If I were a financial manager for a type A firm, I would suggest that the firm provide investors with as much information as possible. Information is the basis of decisions. Being that type A is a low-risk firm and in good financial health, providing good information will attract investors.

Your parents give you $2,000 as a graduation gift and you decide to invest the money in the stock market. If you are risk averse, should you purchase some stock in a few different companies through a website with low transaction fees or put the entire $2,000 into a mutual fund? Explain your answer.

If someone was risk averse, I would put the entire $2,000 into a mutual fund. I think that there is more risk in trying to pick and choose stock in a few different companies through a website. Putting the money into a mutual fund is a better way to diversify the money, as mutual funds give you a wider pool of companies to invest in.

In 2002, the trustworthiness of corporate financial reporting was called into question when a number of companies corrected their financial statements for past years. What impact did their action have on the financial markets?

In 2002 when a number of companies corrected their financial statements from past years, consumers grew concerned and were worried that they weren't able to determine good firms from bad firms. Demand decreased and consumers grew more hesitant before investing. Market prices decreased because of the decreased demand.

The Internet can have a significant influence on asymmetric information problems. a. How can the Internet help to solve information problems? b. Can the Internet compound some information problems? c. On which problem would the Internet have a greater impact, adverse selection or moral hazard?

The Internet can solve information problems because it provides consumers with easy access to information and helps to balance out the asymmetry. It is easy to gather information quickly from something as simple as a Google search. The information can compound some information problems because not everything found online is factual and true. Researchers need to use discernment. Without being careful, researchers could actually compound their problems by using and trusting false information and basing information off of inaccuracies. The Internet provides information to reduce adverse selection. It doesn't do much to reduce moral hazard.

Describe the problem of asymmetric information that an employer faces in hiring a new employee. What solutions can you think of? Does the problem persist after the person has been hired? If so, how and what can be done about it? Is the problem more or less severe for employees on a fixed salary? Why or why not?

The problem of asymmetric information that an employer faces in hiring a new employee is that a large amount of trust is involved. An employer is trusting that the employee was honest in his or her interview, that the information provided on their resume and application materials was accurate, and that their references are giving good insight on the employee. Employers run the risk of being disappointed by their hires. They may not perform as expected or work out in ways that the employer had anticipated. To try to avoid this problem, employers should try to collect as much information as they can before they make the decision to hire someone. After hiring, conducting probationary periods where employees may be easily terminated is one way to try to solve this problem. This problem is more severe for employees on a fixed salary. If an employee is not working hard, a fixed salary does not offer any incentives or motivation for the employee to try to perform better. An alternative would be to give salaries based on performance. Even giving a lower base salary with commission would be more effective.