HW_9_Solutions_Chapter_15_17[1] - Chapter 15 Why Do...

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Chapter 15 Why Do Financial Institutions Exist? s Answers to End-of-Chapter Questions 7. Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and prosecuting fraud. 8. Yes. The person who is putting her life savings into her business has more to lose if the business takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off. 9. Yes, this is an example of an adverse selection problem. Because a person is rich, the people who are most likely to want to marry him or her are gold diggers. Rich people thus may want to be extra careful to screen out those who are just interested in their money from those who want to marry for love. 10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less because the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe a problem. s 1. You are in the market for a used car. At a used car lot, you known that the blue book value for the cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you only care about the expected value of the car you buy and that the car values are symmetrically distributed. Solution:
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This note was uploaded on 09/07/2011 for the course FIN 353 taught by Professor Cobus during the Spring '08 term at S.F. State.

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HW_9_Solutions_Chapter_15_17[1] - Chapter 15 Why Do...

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