Chapter 9

Question 1

What are the eight basic facts?

Answer 1

1. Stocks are not the most important sources of external financing for businesses
2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
3. Indirect finance (involving the activities of financial intermediaries) is many times more important than direct finance (raising funds directly from lenders)
4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses
5. The financial system is among the most heavily regulated sectors of the economy
6. Only large, well-established corporations have easy access to securities markets to finance their activities
7. A prevalent feature of debt contracts for both households and businesses is collateral
   - Property pledged to a lender to guarantee payment
   - Collateralized debt is known as secured debt
8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers

Question 2

What are transaction costs?

Answer 2

They are a major problem in financial markets

Question 3

How have financial intermediaries evolved?

Answer 3

They have evolved to reduce transaction costs

Question 4

What is asymmetric information?

Answer 4

It is when one party has insufficient knowledge about the other party involved in a transaction

Question 5

What are the two types of asymmetric information?

Answer 5

Adverse selection occurs before the transaction
Moral hazard arises after the transaction

Question 6

What is agency theory?

Answer 6

It is a theory that analyses how asymmetric information problems affect economic behaviour

Question 7

What are the tools that help solve adverse selection problems?

Answer 7

Private production and sale of information
Government regulation to increase information
Financial intermediation
Collateral and net worth

Question 8

What is the Principal-Agent Problem?

Answer 8

It is when the principal (the stockholder) has less information than the agent (the manager) which leads to the separation of ownership and control of the firm where managers pursue personal benefits and power rather than the profitability of the firm

Question 9

What are the tools to help solve the principal-agent problem?

Answer 9

Monitoring
Government regulation to increase information
Financial intermediation
Debt contracts

Question 10

How do moral hazards influence the financial structure in debt markets?

Answer 10

Borrowers have incentive to take on projects that are riskier than the lenders would like which prevents the borrower from paying back the loan

Question 11

What are the tools to help solve moral hazard in debt contracts?

Answer 11

Net worth and collateral which makes debt incentive comparable
Monitoring and enforcement of restrictive covenants
Financial intermediation

Question 12

What are the tools used to solve moral hazard in equity contracts?

Answer 12

Government regulation to increase information
Financial intermediation

Question 13

What are the tools to solve moral hazard in debt contracts?

Answer 13

Debt contracts
Collateral and net worth
Monitoring and enforcement of restrictive covenants
Financial intermediation