WorksheetsFinancial Structure Quiz
Total questions: 73
Worksheet time: 54mins
The current structure of financial markets can be best understood as the result of attempts by financial market participants to
adapt to continually changing government regulations.
deal with the great number of small firms in the United States.
reduce transaction costs.
cartelize the provision of financial services.
The reduction in transactions costs per dollar of investment as the size of transactions increases is
discounting.
economies of scale.
economies of trade.
diversification.
Which of the following is not a benefit to an individual purchasing a mutual fund?
reduced risk
lower transactions costs
free-riding
diversification
Financial intermediaries develop ________ in things such as computer technology which allows them to lower transactions costs.
expertise
diversification
regulations
equity
Financial intermediaries' low transaction costs allow them to provide ________ services that make it easier for customers to conduct transactions.
liquidity
conduction
transcendental
equitable
How does a mutual fund lower transactions costs through economies of scale?
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
moral hazard.
asymmetric information.
noncollateralized risk.
adverse selection.
The presence of ________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets.
ncial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets.
noncollateralized risk
free-riding
asymmetric information
costly state verification
The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________.
adverse selection; moral hazard
moral hazard; adverse selection
costly state verification; free-riding
free-riding; costly state verification
If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of
moral hazard.
adverse selection.
free-riding.
costly state verification.
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.
moral hazard
adverse selection
costly state verification
agency
The analysis of how asymmetric information problems affect economic behavior is called ________ theory.
uneven
parallel
principal
agency
The 'lemons problem' exists because of
transactions costs.
economies of scale.
rational expectations.
asymmetric information.
Because of the 'lemons problem' the price a buyer of a used car pays is
equal to the price of a lemon.
less than the price of a lemon.
equal to the price of a peach.
between the price of a lemon and a peach.
Adverse selection is a problem associated with equity and debt contracts arising from
the lenderʹs relative lack of information about the borrowerʹs potential returns and risks of his investment activities.
the lenderʹs inability to legally require sufficient collateral to cover a 100% loss if the borrower defaults.
the borrowerʹs lack of incentive to seek a loan for highly risky investments.
the lenderʹs inability to restrict the borrower from changing his behavior once given a loan.
The ________ problem helps to explain why the private production and sale of information cannot eliminate ________.
free-rider; adverse selection
free-rider; moral hazard
principal-agent; adverse selection
principal-agent; moral hazard
The free-rider problem occurs because
people who pay for information use it freely.
people who do not pay for information use it.
information can never be sold at any price.
it is never profitable to produce information.
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
Federal Communications Commission.
Federal Trade Commission.
Securities and Exchange Commission.
Federal Reserve System.
Government regulations require publicly traded firms to provide information, reducing
transactions costs.
the need for diversification.
the adverse selection problem.
economies of scale.
A lesson of the Enron collapse is that government regulation
always fails.
can reduce but not eliminate asymmetric information.
increases the problem of asymmetric information.
should be reduced.
That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries
have been afforded special government treatment, since used car dealers do not provide information that is valued by consumers of used cars.
are able to prevent potential competitors from free-riding off the information that they provide.
have failed to solve adverse selection problems in this market because ʺlemonsʺ continue to be traded.
have solved the moral hazard problem by providing valuable information to their customers.
Analysis of adverse selection indicates that financial intermediaries, especially banks,
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.
despite their success in overcoming free-rider problems, nevertheless play a minor role in moving funds to corporations.
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.
must buy securities from corporations to diversify the risk that results from holding non-tradable loans.
The concept of adverse selection helps to explain all of the following except
why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets.
why indirect finance is more important than direct finance as a source of business finance.
why direct finance is more important than indirect finance as a source of business finance.
why the financial system is so heavily regulated.
As information technology improves, the lending role of financial institutions such as banks should ________.
increase somewhat
decrease
stay the same
increase significantly
That only large, well-established corporations have access to securities markets
explains why indirect finance is such an important source of external funds for businesses.
can be explained by the problem of moral hazard.
can be explained by government regulations that prohibit small firms from acquiring funds in securities markets.
explains why newer and smaller corporations rely so heavily on the new issues market for funds.
Because of the adverse selection problem,
good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks.
lenders may refuse loans to individuals with high net worth, because of their greater proclivity to ʺskip town.ʺ
lenders are reluctant to make loans.
Net worth can perform a similar role to ________.
diversification
collateral
intermediation
economies of scale
The problem of adverse selection helps to explain
why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets.
why collateral is an important feature of consumer, but not business, debt contracts.
why direct finance is more important than indirect finance as a source of business finance.
why lenders refuse loans to individuals with high net worth.
The concept of adverse selection helps to explain
why collateral is not a common feature of many debt contracts.
why large, well-established corporations find it so difficult to borrow funds in securities markets.
why financial markets are among the most heavily regulated sectors of the economy.
why stocks are the most important source of external financing for businesses.
How does collateral help to reduce the adverse selection problem in credit market?
A problem for equity contracts is a particular type of ________ called the ________ problem.
adverse selection; principal-agent
moral hazard; principal-agent
adverse selection; free-rider
moral hazard; free-rider
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.
principal-agent
adverse selection
free-rider
debt deflation
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.
principals; agents
principals; principals
agents; agents
agents; principals
The principal-agent problem
occurs when managers have more incentive to maximize profits than the stockholders-owners do.
in financial markets helps to explain why equity is a relatively important source of finance for American business.
would not arise if the owners of the firm had complete information about the activities of the managers.
explains why direct finance is more important than indirect finance.
The recent Enron and Tyco scandals are an example of
the free-rider problem.
the adverse selection problem.
the principal-agent problem.
the 'lemons problem.'
The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is
costly state verification.
the free-rider problem.
costly avoidance.
debt intermediation.
Because information is scarce
helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts.
monitoring managers gives rise to costly state verification.
government regulations, such as standard accounting principles, have no impact on problems such as moral hazard.
developing nations do not rely heavily on banks for business financing.
Government regulations designed to reduce the moral hazard problem include
laws that force firms to adhere to standard accounting principles.
light sentences for those who commit the fraud of hiding and stealing profits.
state verification subsidies.
state licensing restrictions.
One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the
venture capital firm.
money market mutual fund.
pawn broker.
savings and loan association.
A venture capital firm protects its equity investment from moral hazard through which of the following means?
It places people on the board of directors to better monitor the borrowing firm's activities.
It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
It prohibits the borrowing firm from replacing its management.
It requires a 50% stake in the company.
Equity contracts account for a small fraction of external funds raised by American businesses because
costly state verification makes the equity contract less desirable than the debt contract.
of the reduced scope for moral hazard problems under equity contracts, as compared to debt contracts.
equity contracts do not permit borrowing firms to raise additional funds by issuing debt.
there is no moral hazard problem when using a debt contract.
Debt contracts
are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
have a higher cost of state verification than equity contracts.
are used less frequently to raise capital than are equity contracts.
never result in a loss for the lender.
Since they require less monitoring of firms, ________ contracts are used more frequently than ________ contracts to raise capital.
debt; equity
equity; debt
debt; loan
equity; stock
Explain the principal-agent problem as it pertains to equity contracts.
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.
moral hazard
agency theory
diversification
the 'lemons' problem
A debt contract is incentive compatible
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.
if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.
if the debt contract is treated like an equity.
if the lender has the incentive to behave in the way that the borrower expects and desires.
High net worth helps to diminish the problem of moral hazard problem by
requiring the state to verify the debt contract.
collateralizing the debt contract.
making the debt contract incentive compatible.
giving the debt contract characteristics of equity contracts.
One way of describing the solution that high net worth provides to the moral hazard problem is to say that it
collateralizes the debt contract.
makes the debt contract incentive compatible.
state verifies the debt contract.
removes all of the risk in the debt contract.
A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a
collateral-insurance clause.
prescription covenant.
restrictive covenant.
proscription covenant.
Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are
limited-liability clauses.
risk insurance.
restrictive covenants.
illegal.
For restrictive covenants to help reduce the moral hazard problem they must be ________ by the lender.
monitored and enforced
written in all capitals
easily changed
impossible to remove
Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that
borrowers may find loopholes that make the covenants ineffective.
they are inexpensive to monitor and enforce.
too many resources may be devoted to monitoring and enforcing them, as debtholders duplicate others' monitoring and enforcement efforts.
they reduce the value of the debt contract.
Solutions to the moral hazard problem include
low net worth.
monitoring and enforcement of restrictive covenants.
greater reliance on equity contracts and less on debt contracts.
greater reliance on debt c
moral hazard problem include
low net worth.
monitoring and enforcement of restrictive covenants.
greater reliance on equity contracts and less on debt contracts.
greater reliance on debt contracts than financial intermediaries.
A key finding of the economic analysis of financial structure is that
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.
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.
given the great extent to which securities markets are regulated, free-rider problems are not of significant economic consequence in these markets.
economists do not have a very good explanation for why securities markets are so heavily regulated.
One reason financial systems in developing and transition countries are underdeveloped is
they have weak links to their governments.
they make loans only to nonprofit entities.
the legal system may be poor making it difficult to enforce restrictive covenants.
the accounting standards are too stringent for the banks to meet.
One reason China has been able to grow so rapidly even though its financial development is still in its early stages is
the high savings rate of around 40%.
the shift of labor to the agricultural sector.
the stringent enforcement of financial contracts.
the ease of obtaining high-quality information about creditors.
Why does the free-rider problem occur in the debt market?
The presence of economies of scope may benefit financial institutions but may create potential costs from ________.
conflicts of interest
multiple profitable enterprises
economies of scale
unsecured debt
Because conflicts of interest increase asymmetric information problems
the economy will not operate as efficiently.
loans will not be made.
banks will not be able to make a profit.
the financial markets will operate more smoothly.
Investment banks ________ companies issuing securities and ________ these securities by selling them to the public on behalf of the issuing companies.
research; underwrite
research; monitor
monitor; underwrite
monitor; manipulate
A conflict of interest arises in investment banking because the banks are attempting to simultaneously serve two client groups
the security-issuing firms and the security-buying investors.
the government and the stockholders.
the government and the security-issuing firms.
the security-issuing firms and the lawyers.
The practice of ________ is allocating initially underpriced initial public offerings to executives in companies the investment bank hopes to do underwriting business with in the future.
The practice of ________ is allocating initially underpriced initial public offerings to executives in companies the investment bank hopes to do underwriting business with in the future.
discounting
spinning
peppering
wiring
A conflict of interest can occur for accounting firms when the firms both
provide auditing services and nonaudit consulting services.
provide nonaudit services and tax advice.
enter data and record data.
monitor data and underwrite securities.
Credit-rating agencies may face a conflict of interest because they
both advise clients on how to structure debt issues and determine the creditworthiness of the debt issues.
underwrite securities and advise clients on how to structure debt issues.
underwrite securities and determine the creditworthiness of the debt issues.
both advise clients on how to structure debt issues and write restrictive covenants.
The fact that the credit-rating agencies both advised clients on how to structure the financial instruments that paid out cash flows from subprime mortgages and also rated these financial instruments contributed to the
subprime financial crisis that began in 2007.
Enron collapse.
demise of Arthur Andersen.
technology bust.
All of the following are credit-rating agency reforms proposed by the SEC in 2008 except
prohibit credit-rating agencies from structuring the same products that they rate.
disclose historical ratings performance.
differentiate the ratings on structured products from those issued on bonds.
sever links between research and securities underwriting.
The Sarbanes-Oxley Act of 2002 increased supervisory oversight by
giving the FDIC the authority to review independent audits.
increasing the SECʹs budget to supervise securities markets.
creating a new Department of Conflict Resolution.
reducing the penalties for obstruction of an official investigation.
While Sarbanes-Oxley is designed to reduce the problems caused by conflicts of interest critics say that it might diminish economies of scope and
reduce information in financial markets.
encourage IPOs in the U.S.
encourage smaller firms to list on the U.S. financial markets.
increase U.S. capital markets relative to those abroad.
The Global Legal Settlement of 2002 required investment banks to separate ________ and ________.
research; securities underwriting
deposits; securities underwriting
research; legal analysis
deposits; legal analysis
What three types of financial service activities have led to serious conflict of interest problems in financial markets in recent years?
