International Finance 5

Of the following sources of external finance for American non financial business, the least important is stocks
Of the follow sources of external finance for American non financial business, the most important is nonbank loans.
Which of the following is not one of the eight basic facts about financial structure? New security issues is the most important source of external funds to finance businesses.
Because information is scarce, monitoring managers gives rise to costly state verification; government regulations, such as standard accounting principles, can help reduce moral hazard
Which of the following best explains the recent decline in the role of financial intermediaries? improvements in information technology
(I) The total cost of carrying out a transaction in financial markets increases proportionally with the size of the transaction. (II) Financial intermediaries facilitate diversification when an investor has only a small sum to invest. (I) is False; (II) is True
If bad credit risks are the ones who most actively seek loans and, therefore, receive them from financial intermediaries, then financial intermediaries face the problem of adverse selection
If borrowers take on big risks after obtaining a loan, then lenders face the problem of moral hazard
Because of the lemons problem in the used car market, the average quality of the used cars offered for sale will be ____, which gives rise to the problem of _____. low; adverse selection
In the use car market, asymmetric information leads to the lemons problem because the price that buyers are willing to pay will reflect the average quality of used cars in the market
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.
A borrower who takes out a loan usually has better information about the potential returns and risks of the investment projects he plans to undertake than the lender does. This inequality of information is called asymmetric information
Adverse selection is a problem associated with equity and debt contracts arising from the lender’s relative lack of information about the borrower’s potential returns and risks of his investment activities
Moral hazard is a problem associated with debt and equity contracts arising from the borrower’s incentive to undertake highly risky investments; the owners’ inability to ensure that managers will act in the owners’ interest.
Because of the adverse selection problem, lenders may make a disproportionate amount of loans to bad credit risks; lenders may refuse loans to individuals with low net worth; lenders are reluctant to make loans that are not secured by collateral.
The ______ problem occurs when people who do not pay for information take advantage of the information that other people have paid for. free-rider
Because of the adverse selection problem, lenders are reluctant to make loans that are not secured by collateral
The problem of adverse selection helps to explain why banks prefer to make loans secured by collateral; why banks have a comparative advantage in raising funds for American businesses; why borrowers are willing to offer collateral to secure their promises to repay loans.
The problem of adverse selection helps to explain which firms are more likely to obtain funds from banks and other financial intermediaries, rather than fro securities markets
When an accounting firm conducts on independent audit, the accounting firms certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings.
The concept of adverse selection helps to explain why financial markets are among the most heavily regulated sectors of the economy.
That most used cars are sold by intermediaries provides evidence that these intermediaries are able to prevent potential competitors from free-riding off the information that they provide
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.
An audit certifies that a firm abides by standard accounting principles
Financial intermediaries (banks in particular) have the ability to avoid the free-rider problem as long as they primarily make private loans
Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called collateral
Collateral is property that is pledged to the lender if a borrower cannot make his or her debt payments; a prevalent feature of debt contracts for households; a prevalent feature of debt contracts for businesses.
Because of the moral hazard problem, lenders will write debt contracts that restrict certain activities of borrowers; lenders will more readily lend to borrowers with high net worth.
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
Because managers (____) have less incentive to maximize profits than the stockholders-owners (_______) do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities. agents; principals
The principal-agenet problem would not arise if the owners of the firm had complete information about the activities of the managers.
Solutions to the moral hazard problem include high net worth; monitoring and enforcement of restrictive covenants.
One financial intermediary in our financial structure that helps to reduce the moral hazard arising from the principal-agent problem is the venture capital firm.
A venture capital firm protects 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 anyone but the venture capital firm.
Debt contracts are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals; have an advantage over equity contracts in that they have a lower cost of state verification; are used much more frequently to raise capital than equity contracts.
Equity contracts account for small fraction of external funds raised by American businesses because costly state verification makes the equity contract less desirable than the debt contract; theres is greater scope for moral hazard problems under equity contracts, as compared to debt contracts.
A debt contract is said to be incentive compatible if The borrower’s net worth reduces the probability of moral hazard
A debt contract is more likely to be incentive compatible if owners of the firm have more of their own money in the business.
Governments in developing countries sometimes adopt policies that retard the efficient operation no their financial systems. These actions include policies that prevent lenders from foreclosing on borrowers with political clout; nationalize banks and direct credit to politically favored borrowers; make it costly to collect payments and collateral from defaulting debtors.
Economies of scale can be used to an advantage by reducing transaction cost.
Net worth is the difference between assets and liabilities
Economies of scope refer to cost savings that arise when the number of different activities undertaken increases.
A financial institution can achieve cost savings by engaging in multiple activities. These are called economies of scope
A financial institution can achieve cost savings in its credit card operations if it increases the number of cardholders. This is an example of economies of scale
Which combination of activities within a single financial institution is least likely to lead to conflicts of interest? consumer lending and business lending
Conflicts of interest pose a problem because they lower the quality of information; increase problems of asymmetric information; make the financial system less efficient
A conflict of interest occurs when people expected to provide reliable information to the public have incentives not to do so
A conflict of interest between providing impartial research about companies issuing securities and selling those same securities arise in investment banking
Spinning is the practice of investment banks allowing executives of potential client companies to buy underpriced IPOs of other companies’ securities
Investment banks are guilty of conflict of interest when they pressure their analysts to produce research favorable to their client firms; permit executives of client firms to alter analysts’ research on their firms; prohibit analysts from making negative or controversial comments about client firms.
Investment banks serve two client groups, issuers of securities and investors in those securities
Auditors attempt to reduce information asymmetry between a firm’s managers and its owners
Conflicts of interest in the Arthur Andersen accounting firm intensified when _______ became the firm’s largest source of profits and large clients pressured _______ office managers to give favorable audits. consulting; regional
The potential conflict of interest when a single accounting firm provides both auditing and consulting services is that that firm can provide unjustifiably favorable audit reviews for firms that are large clients for its consulting services
The conflict of interest in credit-rating agencies arises because ______ pay to have securities rated and, as a result, the agencies’ ratings may be biased _______. security issuers; upward.
During the 2007-2009 financial crisis, housing prices began to fall and subprime mortgages began to default. Which of the following statements is true about he rating of subprime mortgage products? Many AAA-rated subprime products had to be downgraded over and over again until they reached junk status.
Since firms issuing new securities pay to have these securities rated, the credit-rating agencies have incentive to ______ to attract more business. give favorable ratings
The Global League Settlement of 2002 dealt with conflicts of interest in investment banks
American businesses get more funds from direct financing than from indirect financing. False
One reason why indirect financing is used is to minimize adverse selection problems. True
Issuing marketable securities is the primary way businesses finance their operations. False
Because of the adverse selection problem, lenders may refuse loans to individuals with low net worth True
The concept of adverse selection helps to explain why indirect finance is more important than direct finance as a source of business finance. True
The problem of adverse selection helps to explain why direct finance is more important than indirect finance as a source of business finance. False
The concept of adverse select on helps explain why collateral is an important feature of many debt contracts True
One way of describing the solution that high net worth provides to the moral hazard problem is to say that it makes debt contracts incentive compatible. True
Net worth is the difference between a firm’s assets and its liabilities True
The Sarbanes-Oxley Act of 2002 was passed in response to scandals in the investment banking industry False

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