Topic 1: Investment Finance & The Selection Problem - Standard debt market

Question 1

Two economic agents–The leader (who proposes the contract) is called the …….. and the follower (the party who just has to accept or reject the contract) is called the ……

Answer 1

Principal/Agent

Question 1

Two parties interact with asymmetric information. The principal is the ………. party (except in some type of games) and the agent is the ……… party.

Examples:
–A client hires a lawyer of unknown quality; furthermore, the client is unable to control the amount of effort devoted to the case.
–A house owner hires a plumber.
–A car owner hires a mechanic.

Answer 1

uninformed/informed

Question 2

asymmetric information can cause

Answer 2

– market failures (projects with gross returns that are large enough for lenders to lend do not get funded),
– distributional problems

Question 3

We shall use the words ‘loan’, ‘….’ and ‘…….’ interchangeably

Answer 3

debt, credit

Question 4

Project i is unsuccessful with probability:

Answer 4

1-P_i

Question 5

Project i is successful with probability :

Answer 5

p_i

Question 6

When Project i is unsuccessful it yield a return of R_i = ….
(worst that can happen is that the project return equals the project cost)

Answer 6

K

Question 7

Although banks are ignorant about the characteristics of any individual entrepreneur’s project, we assume they do know:

Answer 7

• The distribution of the different types of project across the population of entrepreneurs
• The value of the common expected gross return, M

Question 8

Banks loan K in return for (1+r) K if the project is ………. (r is the interest rate) and K if it is not.

Answer 8

successful