Q&A Hero

Q: When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called A) deleveraging. B) releveraging. C) capitulation. D) deflation.

Q: When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a A) credit boom. B) credit bust. C) deleveraging. D) market race.

Q: Financial crises in advanced economies might start from a A) debt deflation. B) currency crisis. C) mismanagement of financial innovations. D) currency mismatch.

Q: A serious consequence of a financial crisis is A) a contraction in economic activity. B) an increase in asset prices. C) financial engineering. D) financial globalization.

Q: A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system A) causes severe adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently. B) allows for a more efficient use of funds. C) increases economic activity. D) reduces uncertainty in the economy and increases market efficiency.

Q: A major disruption in financial markets characterized by sharp declines in asset prices and firm failures is called a A) financial crisis. B) fiscal imbalance. C) free-rider problem. D) "lemons" problem.

Q: 9.1 What is a Financial Crisis?

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

Q: The high growth rate in China in the last twenty years has similarities to the high growth rate of ________ during the 1950s and 1960s. A) the United States B) the Soviet Union C) Brazil D) Mexico

Q: One reason China has been able to grow so rapidly even though its financial development is still in its early stages is A) the high savings rate of around 40%. B) the shift of labor to the agricultural sector. C) the stringent enforcement of financial contracts. D) the ease of obtaining high-quality information about creditors.

Q: 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.

Q: 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.

Q: A key finding of the economic analysis of financial structure is that A) the existence of the free-rider problem for traded securities helps to explain why banks play a predominant role in financing the activities of businesses. B) while free-rider problems limit the extent to which securities markets finance some business activities, nevertheless the majority of funds going to businesses are channeled through securities markets. C) given the great extent to which securities markets are regulated, free-rider problems are not of significant economic consequence in these markets. D) economists do not have a very good explanation for why securities markets are so heavily regulated.

Q: 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.

Q: 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.

Q: 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

Q: 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.

Q: 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.

Q: 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.

Q: 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.

Q: 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.

Q: 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

Q: 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

Q: 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.

Q: 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.

Q: One way the venture capital firm avoids the free-rider problem is by A) prohibiting the sale of equity in the firm to anyone except the venture capital firm. B) prohibiting members from serving on the board of directors. C) prohibiting the borrowing firm from replacing management. D) requiring collateral equal to the value of the borrowed funds.

Q: A venture capital firm protects its equity investment from moral hazard through which of the following means? A) It places people on the board of directors to better monitor the borrowing firm's activities. B) It writes contracts that prohibit the sale of an equity investment to the venture capital firm. C) It prohibits the borrowing firm from replacing its management. D) It requires a 50% stake in the company.

Q: 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.

Q: 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.

Q: 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.

Q: The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is A) costly state verification. B) the free-rider problem. C) costly avoidance. D) debt intermediation.

Q: The recent Enron and Tyco scandals are an example of A) the free-rider problem. B) the adverse selection problem. C) the principal-agent problem. D) the "lemons problem."

Q: 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

Q: 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.

Q: 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

Q: 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

Q: 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

Q: 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.

Q: How does collateral help to reduce the adverse selection problem in credit market?

Q: 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.

Q: 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.

Q: Net worth can perform a similar role to A) diversification. B) collateral. C) intermediation. D) economies of scale.

Q: 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.

Q: 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.

Q: External financing by ________ should be more important in developing countries than in industrialized countries because information about private firms is more difficult to collect in developing countries. A) financial intermediaries B) bonds C) stock D) direct lending

Q: 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.

Q: 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.

Q: 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.

Q: 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.

Q: A lesson of the Enron collapse is that government regulation A) always fails. B) can reduce but not eliminate asymmetric information. C) increases the problem of asymmetric information. D) should be reduced.

Q: 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.

Q: In the United States, the government agency requiring that firms that sell securities in public markets adhere to standard accounting principles and disclose information about their sales, assets, and earnings is the A) Federal Communications Commission. B) Federal Trade Commission. C) Securities and Exchange Commission. D) Federal Reserve System.

Q: The free-rider problem occurs because A) people who pay for information use it freely. B) people who do not pay for information use it. C) information can never be sold at any price. D) it is never profitable to produce information.

Q: 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

Q: Adverse selection is a problem associated with equity and debt contracts arising from A) the lender's relative lack of information about the borrower's potential returns and risks of his investment activities. B) the lender's inability to legally require sufficient collateral to cover a 100% loss if the borrower defaults. C) the borrower's lack of incentive to seek a loan for highly risky investments. D) the lender's inability to restrict the borrower from changing his behavior once given a loan.

Q: Because of the "lemons problem" the price a buyer of a used car pays is A) equal to the price of a lemon. B) less than the price of a lemon. C) equal to the price of a peach. D) between the price of a lemon and a peach.

Q: The "lemons problem" exists because of A) transactions costs. B) economies of scale. C) rational expectations. D) asymmetric information.

Q: The analysis of how asymmetric information problems affect economic behavior is called ________ theory. A) uneven B) parallel C) principal D) agency

Q: 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

Q: 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.

Q: 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.

Q: 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

Q: 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.

Q: How does a mutual fund lower transactions costs through economies of scale?

Q: 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

Q: Financial intermediaries develop ________ in things such as computer technology which allows them to lower transactions costs. A) expertise B) diversification C) regulations D) equity

Q: Which of the following is not a benefit to an individual purchasing a mutual fund? A) reduced risk B) lower transactions costs C) free-riding D) diversification

Q: 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.

Q: 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.

Q: The current structure of financial markets can be best understood as the result of attempts by financial market participants to A) adapt to continually changing government regulations. B) deal with the great number of small firms in the United States. C) reduce transaction costs. D) cartelize the provision of financial services.

Q: Which of the following is not one of the eight basic puzzles about financial structure? A) Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower. B) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. C) Collateral is a prevalent feature of debt contracts for both households and business. D) There is very little regulation of the financial system.

Q: Which of the following is not one of the eight basic puzzles about financial structure? A) Stocks are the most important source of finance for American businesses. B) Issuing marketable securities is not the primary way businesses finance their operations. C) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. D) Banks are the most important source of external funds to finance businesses.

Q: 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.

Q: 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

Q: Commercial and farm mortgages, in which property is pledged as collateral, account for A) one-quarter of borrowing by nonfinancial businesses. B) one-half of borrowing by nonfinancial businesses. C) one-twentieth of borrowing by nonfinancial businesses. D) two-thirds of borrowing by nonfinancial businesses.

Q: 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

Q: The predominant form of household debt is A) consumer installment debt. B) collateralized debt. C) unsecured debt. D) unrestricted debt.

Q: Credit card debt is A) secured debt. B) unsecured debt. C) restricted debt. D) unrestricted debt.

Q: Collateralized debt is also know as A) unsecured debt. B) secured debt. C) unrestricted debt. D) promissory debt.

Q: 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.