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chapter
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Asymmetric Information
in the Financial System
1. Would each of the following events increase or decrease the volume of bank loans?
Explain.
a. New regulations make it easier for shareholders to replace company directors.
ANSWER: With new regulations that make it easier to replace company directors,
captive boards who are not properly supervising company managers are easier to re-
b. A new law makes it a felony to default on a bank loan.
ANSWER: If it becomes a felony to default on a bank loan, the cost of bank loans in-
creases for potential borrowers. Fewer companies will take out bank loans to finance
investment projects when they are uncertain about the outcome of their projects. In-
c. All the economy’s small firms are bought by large firms.
ANSWER: Large firms are more likely to have a bond rating provided by rating agen-
cies. These ratings decrease adverse selection and make it more likely that firms will
A-44 CHAPTER 7 Asymmetric Information in the Financial System
d. Mutual funds reduce their minimum balances for shareholders.
ANSWER: Reducing the minimum balance for shareholders in mutual funds en-
2. a. Suppose you are hiring a worker for your firm. You advertise a position for
$50,000, but an applicant offers to work for $40,000. Should you jump at this offer?
ANSWER: Paying a salary of $40,000 is only a good deal for the firm if the applicant
is as productive (in relation to the salary paid) as another worker who gets paid the
advertised salary of $50,000. If the firm is hiring the worker for a job that is hard to
monitor, then the worker who gets paid the lower-than-advertised salary is more prone
to goofing off. The moral hazard problem is more pronounced at the lower salary.
b. Suppose you have $1,000 to lend and offer it for 10 percent interest. Someone
promises to pay 20 percent if you lend to him. Should you jump at this offer?
ANSWER: The person offering to pay 20 percent may be engaged in a highly risky
venture that pays high returns if successful, but has a high probability of failure and
3. In what ways is an asset price bubble (described in Section 3.4) similar to a Ponzi
scheme? In what ways is a bubble different?
ANSWER: On the surface, asset-price bubbles and Ponzi schemes are both char-
acterized by rapidly rising asset prices that translate into high returns for savers. How-
ever, in the case of a Ponzi scheme the rapidly rising asset prices are merely an
CHAPTER 7 Asymmetric Information in the Financial System A-45
4. Some U.S. companies have 1-year terms for directors. The entire corporate board
must run for election at each annual meeting. Other companies have 3-year terms;
only a third of directors face votes at each meeting. A 2004 study found that the com-
panies with 3-year terms have lower stock prices, controlling for other factors. What
might explain this finding?
ANSWER: Over the course of a 3-year term, directors may be more likely to become
captive, that is, more likely to align their interests with management rather than share-
5. Why do people commit each of the following crimes? Who is hurt by the crimes?
Discuss who is hurt directly and also the broader effects on the financial system. (As
an analogy, shoplifting hurts store owners directly; its broader effects include higher
prices for goods.)
a. False accounting.
ANSWER: False accounting that makes a firm’s financial situation look better than it
actually is immediately benefits the managers of the firm, who often own stock or
have stock options. This false accounting directly hurts savers who consider buying
a bond issued by this firm. Overstating the firm’s financial situation leads to a higher
b. Insider trading.
ANSWER: Insider trading involves buying or selling securities based on information
that is not public. Insider trading benefits mangers, employees, accountants, and
lawyers, who have more information than the average saver and who can buy stock
before good news becomes public. Insiders are then able to gain from the increase
6. Edward C. Johnson, III was the CEO of Fidelity mutual funds and also the chair of
the Fidelity board. In 2004, the SEC issued a regulation requiring that chairs at mu-
tual funds be independent of management, forcing Johnson to resign as chair. John-
son opposed the SEC action. Here are two arguments he made:
(1) “Mandating an independent chairperson is akin to requiring that every ship have
two captains. . . . If a ship I was sailing on were headed for an iceberg, I’d want one—
and only one—captain giving orders. I’d like to know that he’d spent some time at sea
and knew what he was doing.”
(2) “If a wrong-doer is tempted to try some abuse against fund shareholders, which
board chairman would they rather try sneaking it past—an industry veteran with a di-
rect and personal interest in the fund—or a chairman with 40 years experience mak-
ing carbonated beverages, and who has just flown in for a two-day board meeting?”
Summarize Johnson’s arguments against independent chairs in your own words.
Also suggest responses that might be made by a supporter of the SEC regulation.
ANSWER: Johnson thinks that having one person in charge of the management and
the board of directors will ensure that the company can chart a specific course of ac-
tion and follow it. The SEC concern is with one person being able to chart a specific
course of action directly into the iceberg. In other words, the SEC is concerned that
7. Consider the example in Figure 7.2. Assume that neither firm knows whether its
project is safe or risky. For each firm, there is a 1/2 chance that the project is safe,
producing $125 for sure. There is a 1/2 chance the project is risky, producing $150
with probability 2/3 and zero with probability 1/3. This means that, overall, each firm
has a 1/2 chance of earning $125, a 1/3 chance of earning $150, and a 1/6 chance
of earning zero. Otherwise, make the same assumptions as before. Will the firms be
able to sell bonds? Show your reasoning.
ANSWER: Savers will only buy a bond that has an expected return of $110 and
above. In order to be able to sell a bond, firms have to promise a payment that gen-
erates an expected payment of at least $110. If firms were to promise a payment of
$125, the expected return for a bond holder will be (1/2) $125 + (1/3) × 125 + (1/6) ×
A-46 CHAPTER 7 Asymmetric Information in the Financial System
8. Consider the example in Figure 7.2 with asymmetric information: the two firms
know which one is risky and which is safe, but savers do not. Keep the example the
same as in the figure, except for the earnings of the risky firm. For the following cases,
say whether the safe firm can sell a bond and whether the risky firm can sell a bond.
a. The risky firm’s project earns $150 with probability 3/4, and zero with proba-
bility 1/4.
ANSWER: Savers know that they have a 1/2 probability of buying bonds from the
safe firm and a 1/2 probability of buying bonds from the risky firm, in which case they
only get paid with a probability of 3/4. Overall, savers have a probability of 7/8 of get-
ting paid. In order for them to buy a bond, they have to get a promised payment of
b. The risky firm’s project earns $150 with probability 4/5, and zero with proba-
bility 1/5.
ANSWER: Savers know that they have a 1/2 probability of buying bonds from the
safe firm and a 1/2 probability of buying bonds from the risky firm, in which case they
only get paid with a probability of 4/5. Overall, savers have a probability of 9/10 of get-
ting paid. In order for them to buy a bond, they have to get a promised payment of
9. Consider the example of collateral in Section 7.5. The example assumes that col-
lateral is $50. Determine the smallest level of collateral that causes the firm to choose
the safe project. Assume the firm maximizes its expected profit.
ANSWER: The firm will choose the safe project as long as the risky project gener-
Recall that the risky project generates a profit of $40 with a 2/3 chance. There is a 1/3
chance that the firm will lose the collateral. Solving for x= $35, the smallest level of
CHAPTER 7 Asymmetric Information in the Financial System A-47
10. Suppose you take out a 30-year mortgage of $100,000 with a fixed interest rate
of 5 percent. You must make 360 equal monthly payments. Write an equation that de-
fines what the payment is. (Hint: Use the approach to measuring interest rates in
Section 3.6. The equation is hard to solve without a computer. You may use a mort-
gage calculator on an Internet site.)
ANSWER: A number of mortgage calculators on the Internet are helpful in finding
the answer (e.g., www.bankrate.com/brm/mortgage-calculator.asp). Enter the search
This equation is the familiar present value equation from Chapter 3. Since payments
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
11. Figure 7.3 presents data on IPOs and shareholder rights. The figure gives aver-
ages for four groups of countries. On the text Web site, get data for the 49 individual
countries in the groups. Make a version of the figure that shows the data for each
country. How strong is the relation between IPOs and shareholder rights? Are there
exceptions to the usual relation? What might explain these exceptions?
ANSWER: Creating a graph for all countries with complete data (49 total) shows a
weak positive relationship between the index of shareholder rights and the number
of IPOs per population. Most countries have less than one IPO per population and the
index of shareholder rights ranges over the full range from 0 to 5. However, none of
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12. Do some Internet research to find out what it means for a company to create a
“poison pill.” Why might a company do that? Some economists think poison pills
should be illegal. What is their rationale?
ANSWER: This answer is based on the Internet source Answers.com (www
.answers.com/topic/poison-pill). The poison pill is a defensive strategy used against
hostile corporate takeovers. This strategy is defined as part of a firm’s charter on
CHAPTER 7 Asymmetric Information in the Financial System A-49