American businesses get their external funds primarily from

1. A) bank loans.
2. B) bonds and commercial paper issues.
3. C) stock issues.
4. D) loans from nonbank financial intermediaries.

Answer: D

Of the sources of external funds for nonfinancial businesses in the United States, loans from banks and other financial intermediaries account for approximately ________ of the total.

1. A) 6%
2. B) 40%
3. C) 56%
4. D) 60%

Answer: C

Of the sources of external funds for nonfinancial businesses in the United States, corporate bonds and commercial paper account for approximately ________ of the total.

1. A) 5%
2. B) 10%
3. C) 32%
4. D) 50%

Answer: C

Of the following sources of external finance for American nonfinancial businesses, the least important is

1. A) loans from banks.
2. B) stocks.
3. C) bonds and commercial paper.
4. D) loans from other financial intermediaries.

Answer: B

Of the sources of external funds for nonfinancial businesses in the United States, stocks account for approximately ________ of the total.

1. A) 2%
2. B) 11%
3. C) 20%
4. D) 40%

Answer: B

Of the four sources of external funding for nonfinancial businesses, the least often used in the U.S. is

1. A) bank loans.
2. B) nonbank loans.
3. C) bonds.
4. D) stock.

Answer: D

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE?

1. A) Stocks are a far more important source of finance than are bonds.
2. B) Stocks and bonds, combined, supply less than one-half of the external funds.
3. C) Financial intermediaries are the least important source of external funds for businesses.
4. D) Since 1970, more than half of the new issues of stock have been sold to American households.

Answer: B

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are TRUE?

1. A) Issuing marketable securities is the primary way that they finance their activities.
2. B) Bonds are the least important source of external funds to finance their activities.
3. C) Stocks are a relatively unimportant source of finance for their activities.
4. D) Selling bonds directly to the American household is a major source of funding for American businesses.

Answer: C

With regard to external sources of financing for nonfinancial businesses in the United States, which of the following are accurate statements?

1. A) Marketable securities account for a larger share of external business financing in the United States than in Germany and Japan.
2. B) Since 1970, most of the newly issued corporate bonds and commercial paper have been sold directly to American households.
3. C) Direct finance accounts for more than 50 percent of the external financing of American businesses.
4. D) Smaller businesses almost always raise funds by issuing marketable securities.

Answer: A

Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds

1. A) by issuing stock.
2. B) by issuing bonds.
3. C) from nonbank loans.
4. D) from bank loans.

Answer: D

As a source of funds for nonfinancial businesses, stocks are relatively more important in

1. A) the United States.
2. B) Germany.
3. C) Japan.
4. D) Canada.

Answer: D

Direct finance involves the sale to ________ of marketable securities such as stocks and bonds.

1. A) households
2. B) insurance companies
3. C) pension funds
4. D) financial intermediaries

Answer: A

Regulation of the financial system

1. A) occurs only in the United States.
2. B) protects the jobs of employees of financial institutions.
3. C) protects the wealth of owners of financial institutions.
4. D) ensures the stability of the financial system.

Answer: D

One purpose of regulation of financial markets is to

1. A) limit the profits of financial institutions.
2. B) increase competition among financial institutions.
3. C) promote the provision of information to shareholders, depositors and the public.
4. D) guarantee that the maximum rates of interest are paid on deposits.

Answer: C

Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called

1. A) collateral.
2. B) points.
3. C) interest.
4. D) good faith money.

Answer: A

Collateralized debt is also know as

1. A) unsecured debt.
2. B) secured debt.
3. C) unrestricted debt.
4. D) promissory debt.

Answer: B

Credit card debt is

1. A) secured debt.
2. B) unsecured debt.
3. C) restricted debt.
4. D) unrestricted debt.

Answer: B

The predominant form of household debt is

1. A) consumer installment debt.
2. B) collateralized debt.
3. C) unsecured debt.
4. D) unrestricted debt.

Answer: B

If you default on your auto loan, your car will be repossessed because it has been pledged as ________ for the loan.

1. A) interest
2. B) collateral
3. C) dividend
4. D) commodity

Answer: B

Commercial and farm mortgages, in which property is pledged as collateral, account for

1. A) one-quarter of borrowing by nonfinancial businesses.
2. B) one-half of borrowing by nonfinancial businesses.
3. C) one-twentieth of borrowing by nonfinancial businesses.
4. D) two-thirds of borrowing by nonfinancial businesses.

Answer: A

A ________ is a provision that restricts or specifies certain activities that a borrower can engage in.

1. A) residual claimant
2. B) risk hedge
3. C) restrictive barrier
4. D) restrictive covenant

Answer: D

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of a

1. A) proscriptive covenant.
2. B) prescriptive covenant.
3. C) restrictive covenant.
4. D) constraint-imposed covenant.

Answer: C

Which of the following is NOT one of the eight basic puzzles about financial structure?

1. A) Stocks are the most important source of finance for American businesses.
2. B) Issuing marketable securities is not the primary way businesses finance their operations.
3. C) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
4. D) Banks are the most important source of external funds to finance businesses.

Answer: A

Which of the following is NOT one of the eight basic puzzles about financial structure?

1. A) Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrower.
2. B) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets.
3. C) Collateral is a prevalent feature of debt contracts for both households and business.
4. D) There is very little regulation of the financial system.

Answer: D

The current structure of financial markets can be best understood as the result of attempts by financial market participants to

1. A) adapt to continually changing government regulations.
2. B) deal with the great number of small firms in the United States.
3. C) reduce transaction costs.
4. D) cartelize the provision of financial services.

Answer: C

The reduction in transactions costs per dollar of investment as the size of transactions increases is

1. A) discounting.
2. B) economies of scale.
3. C) economies of trade.
4. D) diversification.

Answer: B

By bundling share purchases of many investors together mutual funds can take advantage of economies of scale and thereby lower

1. A) adverse selection.
2. B) moral hazard.
3. C) transactions costs.
4. D) diversification.

Answer: C

Which of the following is NOT a benefit to an individual purchasing a mutual fund?

1. A) reduced risk
2. B) lower transactions costs
3. C) free-riding
4. D) diversification

Answer: C

Financial intermediaries develop ________ in things such as computer technology which allows them to lower transactions costs.

1. A) expertise
2. B) diversification
3. C) regulations
4. D) equity

Answer: A

Financial intermediaries' low transaction costs allow them to provide ________ services that make it easier for customers to conduct transactions.

1. A) liquidity
2. B) conduction
3. C) transcendental
4. D) equitable

Answer: A

How does a mutual fund lower transactions costs through economies of scale?

Answer: The mutual fund takes the funds of the individuals who have purchased shares and uses them to purchase bonds or stocks. Because the mutual fund will be purchasing large blocks of stocks or bonds they will be able to obtain them at lower transactions costs than the individual purchases of smaller amounts could.

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

1. A) moral hazard.
2. B) asymmetric information.
3. C) noncollateralized risk.
4. D) adverse selection.

Answer: B

The presence of ________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets.

1. A) noncollateralized risk
2. B) free-riding
3. C) asymmetric information
4. D) costly state verification

Answer: C

The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________.

1. A) adverse selection; moral hazard
2. B) moral hazard; adverse selection
3. C) costly state verification; free-riding
4. D) free-riding; costly state verification

Answer: A

If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of

1. A) moral hazard.
2. B) adverse selection.
3. C) free-riding.
4. D) costly state verification.

Answer: B

The problem faced by the lender that the borrower may take on additional risk after receiving the loan is called

1. A) adverse selection.
2. B) moral hazard.
3. C) transactions costs.
4. D) diversification.

Answer: B

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.

1. A) moral hazard
2. B) adverse selection
3. C) costly state verification
4. D) agency

Answer: A

The analysis of how asymmetric information problems affect economic behavior is called ________ theory.

1. A) uneven
2. B) parallel
3. C) principal
4. D) agency

Answer: D

The "lemons problem" exists because of

1. A) transactions costs.
2. B) economies of scale.
3. C) rational expectations.
4. D) asymmetric information.

Answer: D

Because of the "lemons problem" the price a buyer of a used car pays is

1. A) equal to the price of a lemon.
2. B) less than the price of a lemon.
3. C) equal to the price of a peach.
4. D) between the price of a lemon and a peach.

Answer: D

Adverse selection is a problem associated with equity and debt contracts arising from

1. A) the lender's relative lack of information about the borrower's potential returns and risks of his investment activities.
2. B) the lender's inability to legally require sufficient collateral to cover a 100% loss if the borrower defaults.
3. C) the borrower's lack of incentive to seek a loan for highly risky investments.
4. D) the lender's inability to restrict the borrower from changing his behavior once given a loan.

Answer: A

The ________ problem helps to explain why the private production and sale of information cannot eliminate ________.

1. A) free-rider; adverse selection
2. B) free-rider; moral hazard
3. C) principal-agent; adverse selection
4. D) principal-agent; moral hazard

Answer: A

The free-rider problem occurs because

1. A) people who pay for information use it freely.
2. B) people who do not pay for information use it.
3. C) information can never be sold at any price.
4. D) it is never profitable to produce information.

Answer: B

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

1. A) Federal Communications Commission.
2. B) Federal Trade Commission.
3. C) Securities and Exchange Commission.
4. D) Federal Reserve System.

Answer: C

Government regulations require publicly traded firms to provide information, reducing

1. A) transactions costs.
2. B) the need for diversification.
3. C) the adverse selection problem.
4. D) economies of scale.

Answer: C

A lesson of the Enron collapse is that government regulation

1. A) always fails.
2. B) can reduce but not eliminate asymmetric information.
3. C) increases the problem of asymmetric information.
4. D) should be reduced.

Answer: B

That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries

1. A) have been afforded special government treatment, since used car dealers do not provide information that is valued by consumers of used cars.
2. B) are able to prevent potential competitors from free-riding off the information that they provide.
3. C) have failed to solve adverse selection problems in this market because "lemons" continue to be traded.
4. D) have solved the moral hazard problem by providing valuable information to their customers.

Answer: B

Analysis of adverse selection indicates that financial intermediaries, especially banks

1. A) 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.
2. B) despite their success in overcoming free-rider problems, nevertheless play a minor role in moving funds to corporations.
3. C) 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.
4. D) must buy securities from corporations to diversify the risk that results from holding non-tradable loans.

Answer: A

The concept of adverse selection helps to explain all of the following EXCEPT

1. A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets.
2. B) why indirect finance is more important than direct finance as a source of business finance.
3. C) why direct finance is more important than indirect finance as a source of business finance.
4. D) why the financial system is so heavily regulated.

Answer: C

As information technology improves, the lending role of financial institutions such as banks should

1. A) increase somewhat.
2. B) decrease.
3. C) stay the same.
4. D) increase significantly.

Answer: B

External financing by ________ should be more important in developing countries than in industrialized countries because information about private firms is more difficult to collect in developing countries.

1. A) financial intermediaries
2. B) bonds
3. C) stock
4. D) direct lending

Answer: A

That only large, well-established corporations have access to securities markets

1. A) explains why indirect finance is such an important source of external funds for businesses.
2. B) can be explained by the problem of moral hazard.
3. C) can be explained by government regulations that prohibit small firms from acquiring funds in securities markets.
4. D) explains why newer and smaller corporations rely so heavily on the new issues market for funds.

Answer: A

Because of the adverse selection problem

1. A) good credit risks are more likely to seek loans causing lenders to make a disproportionate amount of loans to good credit risks.
2. B) lenders may refuse loans to individuals with high net worth, because of their greater proclivity to "skip town."
3. C) lenders are reluctant to make loans that are not secured by collateral.
4. D) lenders will write debt contracts that restrict certain activities of borrowers.

Answer: C

Net worth can perform a similar role to

1. A) diversification.
2. B) collateral.
3. C) intermediation.
4. D) economies of scale.

Answer: B

The problem of adverse selection helps to explain

1. A) why firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets.
2. B) why collateral is an important feature of consumer, but not business, debt contracts.
3. C) why direct finance is more important than indirect finance as a source of business finance.
4. D) why lenders refuse loans to individuals with high net worth.

Answer: A

The concept of adverse selection helps to explain

1. A) why collateral is not a common feature of many debt contracts.
2. B) why large, well-established corporations find it so difficult to borrow funds in securities markets.
3. C) why financial markets are among the most heavily regulated sectors of the economy.
4. D) why stocks are the most important source of external financing for businesses.

Answer: C

Tools to help solve the adverse selection problem in financial markets include all of the following EXCEPT

1. A) diversification.
2. B) government regulations to increase information.
3. C) the use of financial intermediaries.
4. D) the private production and sale of information.

Answer: A

How does collateral help to reduce the adverse selection problem in credit market?

Answer: Collateral is property that is promised to the lender if the borrower defaults thus reducing the lender's losses. Lenders are more willing to make loans when there is collateral that can be sold if the borrower defaults.

Equity contracts

1. A) are claims to a share in the profits and assets of a business.
2. B) have the advantage over debt contracts of a lower costly state verification.
3. C) are used much more frequently to raise capital than are debt contracts.
4. D) are not subject to the moral hazard problem.

Answer: A

A problem for equity contracts is a particular type of ________ called the ________ problem.

1. A) adverse selection; principal-agent
2. B) moral hazard; principal-agent
3. C) adverse selection; free-rider
4. D) moral hazard; free-rider

Answer: B

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.

1. A) principal-agent
2. B) adverse selection
3. C) free-rider
4. D) debt deflation

Answer: A

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.

1. A) principals; agents
2. B) principals; principals
3. C) agents; agents
4. D) agents; principals

Answer: D

The principal-agent problem

1. A) occurs when managers have more incentive to maximize profits than the stockholders-owners do.
2. B) in financial markets helps to explain why equity is a relatively important source of finance for American business.
3. C) would not arise if the owners of the firm had complete information about the activities of the managers.
4. D) explains why direct finance is more important than indirect finance as a source of business finance.

Answer: C

The principal-agent problem would not occur if ________ of a firm had complete information about actions of the ________.

1. A) owners; customers
2. B) owners; managers
3. C) managers; customers
4. D) managers; owners

Answer: B

The recent Enron and Tyco scandals are an example of

1. A) the free-rider problem.
2. B) the adverse selection problem.
3. C) the principal-agent problem.
4. D) the "lemons problem."

Answer: C

The name economists give the process by which stockholders gather information by frequent monitoring of the firm's activities is

1. A) costly state verification.
2. B) the free-rider problem.
3. C) costly avoidance.
4. D) debt intermediation.

Answer: A

Because information is scarce

1. A) helps explain why equity contracts are used so much more frequently to raise capital than are debt contracts.
2. B) monitoring managers gives rise to costly state verification.
3. C) government regulations, such as standard accounting principles, have no impact on problems such as moral hazard.
4. D) developing nations do not rely heavily on banks for business financing.

Answer: B

Government regulations designed to reduce the moral hazard problem include

1. A) laws that force firms to adhere to standard accounting principles.
2. B) light sentences for those who commit the fraud of hiding and stealing profits.
3. C) state verification subsidies.
4. D) state licensing restrictions.

Answer: A

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the

1. A) venture capital firm.
2. B) money market mutual fund.
3. C) pawn broker.
4. D) savings and loan association.

Answer: A

A venture capital firm protects its equity investment from moral hazard through which of the following means?

1. A) It places people on the board of directors to better monitor the borrowing firm's activities.
2. B) It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
3. C) It prohibits the borrowing firm from replacing its management.
4. D) It requires a 50% stake in the company.

Answer: A

One way the venture capital firm avoids the free-rider problem is by

1. A) prohibiting the sale of equity in the firm to anyone except the venture capital firm.
2. B) prohibiting members from serving on the board of directors.
3. C) prohibiting the borrowing firm from replacing management.
4. D) requiring collateral equal to the value of the borrowed funds.

Answer: A

Equity contracts account for a small fraction of external funds raised by American businesses because

1. A) costly state verification makes the equity contract less desirable than the debt contract.
2. B) of the reduced scope for moral hazard problems under equity contracts, as compared to debt contracts.
3. C) equity contracts do not permit borrowing firms to raise additional funds by issuing debt.
4. D) there is no moral hazard problem when using a debt contract.

Answer: A

Debt contracts

1. A) are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
2. B) have a higher cost of state verification than equity contracts.
3. C) are used less frequently to raise capital than are equity contracts.
4. D) never result in a loss for the lender.

Answer: A

Since they require less monitoring of firms, ________ contracts are used more frequently than ________ contracts to raise capital.

1. A) debt; equity
2. B) equity; debt
3. C) debt; loan
4. D) equity; stock

Answer: A

Solutions to the moral hazard in equity contracts include all of the following EXCEPT

1. A) government regulations to increase information.
2. B) the use of financial intermediaries.
3. C) the use of debt contracts.
4. D) government ownership of resources.

Answer: D

Explain the principal-agent problem as it pertains to equity contracts.

Answer: The principals are the stockholders who own most of the equity. The agents are the managers of the firm who generally own only a small portion of the firm. The problem occurs because the agents may not have as much incentive to profit maximize as the stockholders.

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.

1. A) moral hazard
2. B) agency theory
3. C) diversification
4. D) the "lemons" problem

Answer: A

A debt contract is incentive compatible

1. A) 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.
2. B) if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.
3. C) if the debt contract is treated like an equity.
4. D) if the lender has the incentive to behave in the way that the borrower expects and desires.

Answer: A

High net worth helps to diminish the problem of moral hazard problem by

1. A) requiring the state to verify the debt contract.
2. B) collateralizing the debt contract.
3. C) making the debt contract incentive compatible.
4. D) giving the debt contract characteristics of equity contracts.

Answer: C

One way of describing the solution that high net worth provides to the moral hazard problem is to say that it

1. A) collateralizes the debt contract.
2. B) makes the debt contract incentive compatible.
3. C) state verifies the debt contract.
4. D) removes all of the risk in the debt contract.

Answer: B

A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a

1. A) collateral-insurance clause.
2. B) prescription covenant.
3. C) restrictive covenant.
4. D) proscription covenant.

Answer: C

Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are

1. A) limited-liability clauses.
2. B) risk insurance.
3. C) restrictive covenants.
4. D) illegal.

Answer: C

For restrictive covenants to help reduce the moral hazard problem, they must be ________ by the lender.

1. A) monitored and enforced
2. B) written in all capitals
3. C) easily changed
4. D) impossible to remove

Answer: A

Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that

1. A) borrowers may find loopholes that make the covenants ineffective.
2. B) they are inexpensive to monitor and enforce.
3. C) too many resources may be devoted to monitoring and enforcing them, as debtholders duplicate others' monitoring and enforcement efforts.
4. D) they reduce the value of the debt contract.

Answer: A

Solutions to the moral hazard problem include

1. A) low net worth.
2. B) monitoring and enforcement of restrictive covenants.
3. C) greater reliance on equity contracts and less on debt contracts.
4. D) greater reliance on debt contracts than financial intermediaries.

Answer: B

A key finding of the economic analysis of financial structure is that

1. A) 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.
2. B) 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.
3. C) given the great extent to which securities markets are regulated, free-rider problems are not of significant economic consequence in these markets.
4. D) economists do not have a very good explanation for why securities markets are so heavily regulated.

Answer: A

One possible reason for slower growth in developing and transition countries is

1. A) capital may not be directed to its most productive use.
2. B) strict accounting standards are too stringent for the banks to meet.
3. C) the weak link between government and financial intermediaries.
4. D) the lack of adverse selection and moral hazard problems.

Answer: A

One reason financial systems in developing and transition countries are underdeveloped is

1. A) they have weak links to their governments.
2. B) they make loans only to nonprofit entities.
3. C) the legal system may be poor making it difficult to enforce restrictive covenants.
4. D) the accounting standards are too stringent for the banks to meet.

Answer: C

Because of the weak systems of property rights in many developing and transition economies, the financial system is unable to use collateral effectively worsening the ________ problem.

1. A) adverse selection
2. B) moral hazard
3. C) principal/agent
4. D) diversification

Answer: A

In developing countries, it can be expensive and time-consuming for the poor to legalize their property ownership. Without legal title, the property cannot be used as ________ to borrow funds.

1. A) collateral
2. B) points
3. C) interest
4. D) restrictive covenants

Answer: A

One reason China has been able to grow so rapidly even though its financial development is still in its early stages is

1. A) the high savings rate of around 40%.
2. B) the shift of labor to the agricultural sector.
3. C) the stringent enforcement of financial contracts.
4. D) the ease of obtaining high-quality information about creditors.

Answer: A

The high growth rate in China in the last twenty years has similarities to the high growth rate of ________ during the 1950s and 1960s.

1. A) the United States
2. B) the Soviet Union
3. C) Brazil
4. D) Mexico

Answer: B

Why does the free-rider problem occur in the debt market?

Answer: Restrictive covenants can reduce moral hazard but they must be monitored and enforced to be effective. If bondholders know that other bondholders are monitoring and enforcing the restrictive covenants, they can free ride. Other bondholders will follow suit resulting in not enough resources devoted to monitoring and enforcing restrictive covenants.