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Define transaction costs
The cost of a trade or financial transaction (ex. brokerage commission)
Define information costs
The cost that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired
How do financial intermediaries reduce transaction costs?
Economies of scale. Easier for them to acquire information and reduce transaction costs
Define asymmetric information
The situation in which one party to an economic transaction has better information than does the other party
Define adverse selection
the problem investors face in distinguishing low-risk borrowers from high-risk borrowers before making an investment. If there are characteristics known by one transacting party but not the other (usually borrower knows more) (pre-contractual)
Define moral hazard
the problem investors experience in verifying that borrowers are using their funds as intended (post-contractual)
How is adverse selection seen in the stock market?
Lemon problems make lending in equity markets more costly. If there are two firms, one is lemon and one is good, the market price will be the expected value of both. The low-risk fir…
What is the consequence of adverse selection in the stock market on small and medium-sized firms?
Small and medium-sized firms will be unable/unwilling to issue stock as investors will be afraid to buy them out of fear that they are a lemon firm
How is adverse selection seen in the bond market?
Investors are unwilling to make any loans on high interest rates as they are probably lemon firms. Ex. Managers of firms facing bankruptcy may be willing to pay more to finance risky investments etc. Inves…
Define credit rationing
The restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. Curbs the availability of low cost funds to good companies, reduces production and employment.
List some attempts to reduce adverse selection
SEC was established, firms required to publish reports on performance, private firms created to collect and sell information (rating agencies)
Individuals who gain access to information for free
Assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan
Define net worth
the difference between the value of a firm's assets and the value of its liabilities. When a firm's net worth is high they have more to lose
How do financial intermediaries reduce adverse selection problems?
Banks are good at gathering information about default risk of borrowers
Define relationship banking
The ability of banks to assess credit risk on the basis of private information about borrowers
Describe moral hazard in the stock market
Investors do not know how management will use investment. There is separation of ownership from control
Describe moral hazard as an issue with a firm's management
Often the management only own less than 5% of firm. They can be empire builders or use the firms irresponsibly
Describe moral hazard in the principal-agent problem in the stock market
The moral hazard problem of managers (the agents) pursuing their own interest rather than those of shareholders (the principals)
Define incentive contracts
part of a manger's compensation is tied to performance of the firm
Describe moral hazard in the bond market
Less moral hazard in the bond market than in the stock market because firms only need to make coupon and final payments. Firms have incentive to assume more risk to earn extra profits.
Define restrictive coventants
A clause in a bond contract that places limits on the uses of funds that a borrower received (ex. firm cannot use funds to buy a warehouse)
How do restrictive covenants affect the bond market?
Prevents managers from taking on too much risk but also makes bonds more complicated and reduces marketability. Cost of monitoring is high
How do financial intermediaries reduce moral hazard problems?
Lenders can monitor borrowers and how funds are used (Ex. for a car loan, send check to dealership) (Ex. mortgages, have to carry insurance on house and cannot sell house without repaying first mortgage payment)
Define venture capital firm
A firm that raises equity capital from investors to invest in startup firms. take large part of ownership in a startup, greater ability to monitor managers
Define private equity firm (or corporate restructuring firm)
A firm that raises equity capital to acquire shares in other firms to reduce free-rider and moral hazard problems.