Lecture 4 (Chapter 7)

Question 1

8 basic facts about financial structure

Answer 1

1. Stocks are not the most important “source” to external finance of business
2. Issuing marketable debts and equity securities is not the primary way to finance a firms operation
3. Indirect finance is often more important than direct finance
4. Financial intermediaries, mostly banks, are the most important source of external funds used to finance
5. The financial system is among the most heavily regulated sectors of the economy
6. Only large, well-established firms have easy access to securities markets to finance their operation
7. Most debt contracts are collateralized
8. Debt contracts are extremely complicated with lots of different covenants.

Question 2

Transaction costs?

Answer 2

Costs that adds to the price each time a good is sold or bought.

Question 3

What’s the problem with transaction costs and how can they be solved?

Answer 3

A major problem with transaction costs it can “freeze out” small firms or investors from the market.

Economies of scale can reduce these costs. By creating mutual funds, bigger proportions of shares can be bought which will decrease the transaction cost.

Question 4

Adverse selection? In financial markets?

Answer 4

Oförmånligt urval - Lemon problem. One party on the market has more information about quality than the other has.

Exists in stock and bond market + debt market

Question 5

Adverse selection in stock and bond market?

Answer 5

Investors can’t distinguish bad from good firms and will therefore buy stocks for a lower average price. The good firms will not sell for the lower price and it will end with no trading.

Question 6

Adverse selection on debt markets?

Answer 6

Investors will buy debt issued by a corporation only if the interest on loan is high enough to compensate for the risk. Good firms, who has low default risk will realise that they pay a higher interest rate than they should (and hence be unwilling to borrow). The investor prefers to not buy bonds from bad firms and hence not any bonds at all.

Question 7

Tools to mitigate adverse selection?

Answer 7

1. Private production and sale of information
2. Governement regulation
3. Financial intermediation
4. Colleteral and net worth

Question 8

What does pecking order hypothesis state?

Answer 8

That larger more well known and established firms are more likely to issue equity to raise funds (ge ut aktier för att skaffa pengar)

Question 9

Moral hazard?

Answer 9

Happens after the transaction. The seller can’t see the buyers behavior and has incentives to hide information.

Question 10

Principal agent problem?

Answer 10

The agent makes decisions that affects the principal. The problem occurs because the agent doesn’t have the same incentives as the principal and therefore makes different decisions.

Question 11

Example principal agent problem in stock market?

Answer 11

Principal = owner (share holder)
Agent = manager (controll)
Principal and agents doesn’t have the same incentives about profit. Important for principal to maximize profit manager and not so important to the agent (who has control)