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Unformatted text preview: Economics 121 Pamela Labadie George Washington University Fall 2007 Answers to Exam 2 Provide a brief and concise answer to each question. Clearly label each answer. There are 75 points on the exam. Point allocations are indicated next to the question and correspond approximately to how much time you should allocate to that question. 1. (10 pts) Assume there is a principal-agent problem for corporate equity. Also assume that large institutional share-holders monitor corporate management. (a) Provide a definition of the principal-agent problem Answer: The principal-agent problem refers to a situation where there is asymmetric information between two types of agents, the principal and the agent. The agent is acting on the behalf of the principal, for example the management of a corporation acting on the behalf of shareholders, and the agent has more information than the principal. In general, the incentives of the principal and the agent are different. The main issue typically is how to design a legally binding arrangement that makes the incentives of the principal and agent compatible, despite the superior information of the agent. (b) Discuss whether there is a free rider problem. Is the level of monitoring is optimal from societys point of view? Discuss. The main feature of equity contracts is the separation of ownership and management. Managers know more about the condition and future earnings prospects of the firm, but have incentives that are different from the incentives of the owners, where owners are the principals. Hence the manager may spend funds on expensive offices and company cars, which dont contribute to the return to equity, and may mislead shareholders about the performance of the company. If shareholders monitor the behavior of managers, by examining expenditures and conducting independent audits, for example, then the management may behave in a way that is compatible with the interests of the principal. Monitoring by shareholders is costly. If a few shareholders engage in monitoring, resulting in a greater alignment of interests, then all shareholders benefit. Hence a few shareholders incur the monitoring costs while all shareholders benefit - a classic free rider problem. As a result there may be less than optimal monitoring of management by shareholders. 2. (12 pts) Empirical evidence suggests that interest rates are procyclical. Use the liquidity premium theory of interest rates to describe the typical shape of the yield curve at the peak and trough of a business cycle. Specifically, describe (a) slope and position of the yield curve relative to the average yield curve (b) how expected future short-term interest rates are expected to change at the peak and trough of a business cycle....
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