chapter 9: An Economic Analysis of Financial Structure Flashcards
Eight Basic Facts
- Stocks are not the most important sources of external financing for businesses
- Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations
- Indirect finance is many times more important than direct finance
4 Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses
- The financial system is among the most heavily regulated sectors of the economy
- Only large, well-established corporations have easy access to securities markets to finance their activities
- A prevalent feature of debt contracts for both households and businesses is collateral
- Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
collateral
Property pledged to a lender to guarantee payment
Collateralized debt
secured debt
Transaction costs
a major problem in financial markets
Brokerage fees, for example
Inability to diversify will subject you to risk
how have financial intermediaries evolved to reduce transaction costs?
Economies of scale
Expertise
how have financial intermediaries taken advantage of economies of scale to reduce transaction costs?
cost of transaction increases only slightly for the increased size of transaction
many of the large costs of resources in finance are fixed
the more people making transactions, the lower they will be
how have financial intermediaries taken advantage of expertise to reduce transaction costs?
better service and information about investments
liquidity services (cheque-writing, etc.)
Asymmetric Information
one party has insufficient knowledge about the other party involved in a transaction
problems of asymmetric information
Adverse selection
Moral hazard
Adverse selection
occurs before the transaction
refers to a situation where sellers have more information than buyers have, or vice versa, about some aspect of product quality
Moral hazard
arises after the transaction
the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity
Agency theory
analyses how asymmetric information problems affect economic behaviour
The Lemons Problem
If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality
Sellers of good quality items will not want to sell at the price for average quality
The buyer will decide not to buy at all because all that is left in the market is poor quality items
consequences of the lemon problem
keeps securities markets such as the stock and bond markets from being effective in channeling funds from savers to borrowers
how can asymmetric information lead to the lemon problem in stock and bonds market?
lack of information will make investors struggle in
distinguishing high-profit/low-risk firms from low-profit/high-risk firms
Owners and managers of good firms have better information than the investors, so they would know that their securities are undervalued in the market and won’t bother issuing securities in the first place
the principal agent problem basically
