the economics of money, banking, and financial markets

242 #

© 2014 Pearson Canada Inc.#

14. 
    

    China's reforms to strengthen the financial system includes ____.
    A) privatizing state-owned banks
    B) diluting legal reforms
    C) industrializing the labour force
    D) maintaining highly agrarian labour force
    Answer: A
    Diff: 2 Type: MC Page Ref: 178
    Skill: Recall
    Objective List: 8.3 Discuss why securities regulators are introducing new rules and regulations

    
    


15. 
    

    How do restrictive covenants reduce moral hazard in debt contracts?
    Answer: Restrictive covenants keep borrowers from taking excessive risks. Restrictive
    covenants can encourage desirable behaviour, such as buying insurance to repay the loan in case
    of death of the borrower, and maintaining high net worth. Covenants encourage the borrower to
    keep collateral valuable, including purchasing insurance to protect assets against risk of loss.
    Covenants require borrowers to provide information about activities, including accounting and
    income reports. This reduces moral hazard.
    Diff: 2 Type: SA Page Ref: 173 - 175
    Skill: Recall
    Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
    hazard

    
    


16. 
    

    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.
    Diff: 1 Type: SA Page Ref: 175
    Skill: Recall
    Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
    hazard

    
    


17. 
    

    Explain how high net worth and collateral reduce the problem of moral hazard.
    Answer: High net worth and collateral makes the debt contract incentive-compatible by aligning
    the incentives of the borrowers with those of the lenders.
    Diff: 1 Type: SA Page Ref: 175
    Skill: Recall
    Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
    hazard

    
    


18. 
    

    Explain the difference between net worth and collateral.
    Answer: Net worth is the difference between a borrowers assets and liabilities. Collarateral
    represents assets pledged to the lender.
    Diff: 2 Type: SA Page Ref: 173 - 174
    Skill: Recall
    Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
    hazard