61. Moody’s, Value Line, and Dun and Bradstreet are examples of companies that:
a. provide information free to investors but charge the companies for the ratings provided on the
company.
b. provide information free to investors but recoup expenses through advertising done by the
companies being rated.
c. charge investors who subscribe to the services for the information.
d. duplicate information that is available to investors at no cost.
62. The scandals involving Enron, World Com, Global Crossing and other large firms:
a. are examples of asymmetric information and have led, at least temporarily, to a less well
functioning stock market.
b. is what should have been expected on the part of investors, that is why there is a risk premium.
c. have resulted in a cry for less government regulation of public corporations.
d. demonstrate that the government should be responsible for collecting and distributing financial
information on firms.
63. Requiring that borrowers put up collateral to obtain a loan is a tool designed to treat:
a. the lemons problem.
b. the problem of adverse selection.
c. the problem of moral hazard.
d. the free-rider problem.
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64. Which of the following could the lemons problem, applied to financial markets, explain?
a. Lenders seeing a disproportionate share of high quality loan applicants
b. An average interest rate that is too high for the actual risk obtained
c. Profits for many lenders increasing significantly
d. High quality potential borrowers relying more on internally generated funds to finance
investment
65. An unsecured loan is:
a. a loan where the applicant does not have any net worth.
b. a loan where the applicant does not post any collateral.
c. another name for a mortgage loan.
d. usually a low-risk loan.
66. A home mortgage is a good example of:
a. an unsecured loan.
b. a secured loan.
c. a high risk loan.
d. the problem of adverse selection.
67. Requiring a large net worth on the part of an applicant is one way lenders treat the problem
of:
a. free-riders.
b. adverse selection.
c. moral hazard.
d. the Lemons market.
68. Requiring a home buyer to have a large down payment reduces the risk to a mortgage lender
because:
a. it means that if the price of the house falls, the owner suffers the loss.
b. the buyer is less likely to sell the house.
c. it means the buyer likely underpaid when she bought the house.
d. it means there is more information available on the buyer.
69. Which of the following statements is not true?
a. Home mortgage loans are secured loans.
b. Credit card loans are secured.
c. Most automobile loans are secured loans.
d. Secured loans usually carry less risk than unsecured loans.
70. Which of the following statements is true?
a. Unsecured loans generally involve very high interest rates as a result of the free-rider problem.
b. Unsecured loans generally involve very high interest rates as a result of adverse selection.
c. Unsecured loans are no longer made; all loans now must have some form of collateral.
d. Unsecured loans are only made to individuals with very high net worth because it is the only
way to limit the risk.
71. Deflation compounds information problems because it:
a. increases a company’s net worth.
b. tends to understate a company’s assets and overstate their liabilities.
c. reduces the dollar value of assets while the dollar value of liabilities stays constant.
d. always harms lenders.
72. A borrower who obtains funds from a lender to purchase additional inventory but uses the
funds to finance a trip to Las Vegas for a weekend of gambling at the opening of a new casino is
an example of:
a. the problem of adverse selection.
b. the free-rider.
c. the moral hazard problem.
d. lax government regulation.
73. Credit may dry up at the start of an economic downturn because of all of the following
except:
a. lenders require information and accurate information is more difficult to obtain.
b. it becomes more difficult for lenders to determine the creditworthiness of borrowers.
c. lenders see greater risk in making loans to borrowers.
d. the free-rider problem worsens during a downturn.
74. The principal-agent problem is:
a. a form of adverse selection.
b. when stockholders are not acting in the best interest of managers.
c. a form of moral hazard.
d. due to managers not being able to monitor stockholder behavior.
75. The principal-agent problem is quite common in large public corporations due to:
a. the fact that large corporations generate large sales volumes.
b. the fact that large companies employ many people.
c. too little regulation by government.
d. the fact that the people making the operational decisions are usually not the owners.
76. The fact that many companies employ supervisors to oversee the actions of workers is a way
to treat:
a. moral hazard.
b. adverse selection.
c. the law of diminishing returns.
d. the free-rider problem.
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79. Tom borrows $100,000 from his local bank to purchase inventory for his store for the
upcoming holiday season. Tom’s neighbor tells him about a get-rich-quick scheme that can take
this $100,000 and triple it in a month. Tom decides to buy into this scheme figuring he can repay
the bank and still have plenty left for inventory. This is an example of:
a. adverse selection.
b. sound risk analysis on Tom’s part.
c. diversification.
d. moral hazard.
78. A bank usually treats the moral hazard problem by using all of the following, except:
a. not making loans.
b. requiring collateral.
c. requiring down payments.
d. restrictive covenants.
79. Moral hazard problems arise because:
a. lenders cannot distinguish good from bad risks.
b. borrowers have incentives to act in ways that do not reflect the lender’s interest.
c. firms hire incompetent employees.
d. lenders charge interest rates that are too low.
80. One reason lenders may require a large net worth before making a loan is because:
a. then the borrower does not need the funds.
b. it tells the lender the firm has good employees.
c. it is one way to treat the problem of moral hazard.
d. banking laws require firms have significant net worth before a bank can make a loan.
81. Providing stock options to corporate managers was an idea designed to:
a. hide increases in pay of corporate executives from stockholders.
b. align managers’ interest with the stockholders’ interest.
c. treat adverse selection.
d. treat the free-rider problem.
82. The moral hazard that can result from debt financing is mainly due to the:
a. borrower not working as hard once he or she obtains the loan.
b. borrower wanting to refinance the loan.
c. borrower taking greater risk in hopes of obtaining a larger return.
d. economy turning sour and the borrower defaulting.
83. Each of the following is an example of a restrictive covenant on a mortgage loan, except:
a. net worth requirements.
b. requiring that the borrower reside in a home for which he or she receives a mortgage.
c. insisting the borrower carry physical damage insurance on the property securing the loan.
d. requiring the borrower to obtain comprehensive health insurance.
84. One reason that financial intermediaries exist is that they:
a. are required by government regulation.
b. have developed low-cost methods to obtain information.
c. are the only way to obtain information.
d. earn high returns from lending their own funds.
85. The screening process a bank follows for a loan applicant:
a. uses information that anyone can obtain, the bank can usually obtain it cheaper.
b. includes information that can be available to other firms, as well as proprietary information
that only the bank would have.
c. is based on just public information.
d. uses only confidential information.
86. Large companies seeking to raise funds often will use a well-known investment bank
because:
a. the investment bank’s reputation identifies the company as being credit worthy.
b. they are required to by government regulation.
c. the investment bank is paying the company for the publicity and goodwill it will generate.
d. this minimizes moral hazard.
87. Often a bank will require a loan officer to make personal visits on customers with loans
outstanding. This is encouraged because:
a. the bank worries about another bank trying to steal their customers.
b. the bank wants to make sure the business is busy.
c. this is an effective monitoring technique and should reduce moral hazard.
d. the bank has excess funds available and hopes to make another loan to the business.
Short Answer Questions
88. A friend of yours tells you she has an idea for a new product. She believes that once the
prototype is built she can sell the rights to the product for $250,000. The problem is she needs
$20,000 to build the prototype and she only has $5,000. She asks you to invest $15,000 in the
idea and she will give you 75% of whatever amount she obtains when she sells the rights. You
have the money available but should be reluctant to provide the money. Why?
89. Please explain how financial intermediaries contribute to increasing the output of an
economy.
90. What is the difference between economies of scale and economies of scope? Provide an
example of each that pertains to financial institutions.
91. Is the conflict between a lender to a firm and the borrower/owner an example of adverse
selection or moral hazard? Explain.
92. If a lender faces a potential loan applicant pool made up of equal amounts of low risks and
high risks, will charging an average interest rate provide the average (expected) return? Explain.
93. Explain how Federal Deposit Insurance (FDIC) could potentially create a moral hazard for
the managers of deposit institutions.
94. Why is it that financial intermediaries are so important in most economies?
95. What are the five functions performed by financial intermediaries?
96. Provide an example of how a bank achieves lower cost in making a large loan to a company
than could be achieved without the bank.
97. If diversification is such a good idea for a saver, why do so many people put a lot of their
savings in the same bank?
98. Explain how mutual funds offer small investors a low-cost way to achieve diversification.
99. If buyers cannot distinguish a good used car, worth $15,000, from a “lemon,” worth $5,000;
explain what will happen to the market for used cars.
100. A bank advertises a very competitive loan interest rate. Explain what measures the bank
can take to address adverse selection.
101. Discuss the role that companies like Standard & Poor’s, Dun & Bradstreet, and Moody’s
play in solving the problem of adverse selection.
102. Respond to the following: “If it takes a significant period of time to uncover accounting
manipulations by individuals in a major corporation, honesty may be the best policy but
dishonesty can be a lot more profitable!”
103. Explain the difference between a secured and an unsecured loan, and the interest rate you
would expect to see charged on each (all other factors equal).
104. Explain what is likely to happen to the rate of mortgage loan default given the following:
“For years home values across the country have increased on average 3 to 4% percent each year.
Mortgage lenders have come to expect this to always be the case and so begin to offer mortgages
with little to nothing down and not requiring PMI insurance. An economic slowdown occurs
hitting a few areas of the country harder than others. Home values across the country begin to
decrease with some areas seeing decreases of as much as 10%.”
105. Explain why deflation can be so troubling to borrowers and lenders.
106. Life insurance companies usually offer a lower premium to non-smokers than the premium
charged to smokers. Discuss first the potential for adverse selection and moral hazard and then
ways the company can seek to reduce or eliminate these problems.
107. You have a friend that has run up a pretty large balance on his credit card. He mentions to
you that he has missed a few payments but doesn’t think it is that big of a deal since all it cost
him is a little more interest on his balance. You tell him it may end up costing him a lot more
that. He presses you for an explanation. Explain to him how his handling of this debt can impact
what he pays for future debt.
108. It is not uncommon to read about highly successful mutual fund managers that spend
considerable amounts of time visiting the companies that they have placed their clients’ funds
with. What might be the motive(s) behind these visits?
109. Explain how the threat of a leveraged buyout or a takeover can actually address the
problem of moral hazard.
110. The United States, the United Kingdom, Germany and Japan are all developed countries
with highly developed and efficient financial markets. However, in all four countries the main
source of business finance is internal funding. Why is this so?
Essay Questions
111. Most credit cards charge a relatively high rate of interest, yet many people carry them,
including people who would be considered low-risk borrowers. Our discussion of adverse
selection said that low-risk borrowers should have been discouraged from these. What gives?
112. A friend who is taking her first class in investments asks you why the regulatory bodies
place so much emphasis on minimizing insider information if many of the potential problems
associated with financial transactions stem from information asymmetry or a lack of information.
How would you respond?
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113. How did information asymmetries in the home mortgage market contribute to the financial
crisis of 2007-2009?