TUTORIAL 6

ECONOMIC ANALYSIS OF FINANCIAL STRUCTURE

I. Review questions
1. What are eight basic facts about the global financial system?
2. Explain the problem of transaction cost in the financial market. How this problem
is solved?
3. Describe why asymmetric information leads to adverse selection and moral
hazard.
4. Explain adverse selection and moral hazard problem in debt and equity contracts
and various tools used to reduce them.

II. Multiple choice questions

1. The largest source of external funds for U.S. firms is:
A. loans.
B. bonds.
C. stocks
D. trade debts

2. Asymmetric information occurs when

A. one party in a transaction has more information than another.
B. one party in a transaction has more influence than another.
C. each party in a transaction gains from the transaction.
D. each party has equal information

3. A bad credit risk seeks out loans more actively. This is a(n):
A. adverse selection problem.
B. moral hazard problem.
C. principal-agent problem.
D. liquidity problem

4. A borrower engages in activities that are undesirable from a lender's point of

view. This is the:
A. moral hazard problem.
B. liquidity problem.
C. transaction costs problem.
D. adverse selection problem.

5. The free-rider problem

A. will only occur if information costs are zero.
 B. is that people who do not pay for information take advantage of information
other people have paid for.
C. will make more people willing to provide information services.
D. makes it easier for an investor to continue to buy securities at less than the true
value.

6. The principal-agent problem

A. occurs because owners have complete information about managers.
B. is a type of moral hazard.
C. eliminates costly state verification.
D. is not related to asymmetric information.

7. When interest rates are high, lenders may not want to make loans because of:
A. moral hazard.
B. the principal-agent problem.
C. adverse selection.
D. costly state verification.

8. A venture capital firm:

A. increases the size of the moral hazard problem.
B. pools resources to help entrepreneurs start new firms.
C. allows equity shares of the new firm to be sold in the marketplace.
D. has no say in the management of the new firm.

9. Which of the following describes the "lemons problem?"

A. Sellers have more information than buyers and more transactions occur.
B. Buyers have more information than sellers and more transactions occur.
C. Sellers have more information than buyers and few transactions occur.
D. Buyers have more information than sellers and few transactions occur.

10. By taking advantage of economies of scale and developing expertise, financial

intermediaries overcome the problem of:
A. adverse selection.
B. free-riding.
C. high transaction costs.
D. moral hazard.

11. Regulation of the financial system

A. occurs only in the United States.
B. protects the jobs of employees of financial institutions.
C. protects the wealth of owners of financial institutions.
D. ensures the stability of the financial system.

12. One purpose of regulation of financial markets is to

A. limit the profits of financial institutions.
B. increase competition among financial institutions.
 C. promote the provision of information to shareholders, depositors and the
public.
D. guarantee that the maximum rates of interest are paid on deposits.

13. 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.

14. The predominant form of household debt is

A. consumer installment debt.
B. collateralized debt.
C. unsecured debt.
D. unrestricted debt.

15. Collateralized debt is also known as

A. unsecured debt.
B. unrestricted debt.
C. secured debt.
D. promissory debt.

16. Credit card debt is

A. secured debt.
B. restricted debt.
C. unrestricted debt.
D. unsecured debt.

17. 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

18. 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

19. A clause in a mortgage loan contract requiring the borrower to purchase

homeowner's insurance is an example of a
A. proscriptive covenant.
 B. prescriptive covenant.
C. restrictive covenant.
D. constraint-imposed covenant.

20. 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.

21. 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.

22. As information technology improves, the lending role of financial institutions

such as banks should ________.
A. increase somewhat
B. decrease
C. stay the same
D. increase significantly

23. Net worth can perform a similar role to ________.

A. diversification
B. collateral
C. intermediation
D. economies of scale

III. Practice exercises

Questions taken and apapted from chapter 8 (Mishkin, 2019)

1. How does a mutual fund lower transactions costs through economies of scale?

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

3. What are the transaction costs problems facing financial organizations? Explain how
financial Intermediaries can help reduce these problems.

4. Explain why dating can be considered a method to solve the adverse selection problem.
5. Why are financial intermediaries willing to engage in information collection activities
when investors in financial instruments may be unwilling to do so?

6. Suppose you have data about two groups of countries, one with efficient legal systems
and the other with slow, costly, and inefficient legal systems. Which group of countries
would you expect to exhibit higher living standards?

7. What steps can the government take to reduce asymmetric information problems and
help the financial system function more smoothly and efficiently?

8. Explain how the separation of ownership and control in American corporations might
lead to poor management.