Exam 1: Basic Concepts

Use the following information for questions There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $30, a B car is worth $15, and a U car is worth $0.A buyer cannot distinguish the quality of cars offered for sale, but the seller does.If there is equal probability of a car being G, B, or U, -which car is offered for sale in equilibrium and at what price?

Use the following information for questions . There are two possible states of nature, s = 1, and s = 2, over the next period.There are two securities i and j) whose current prices are $10 and $15, respectively.Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = 2. -What are the prices of the Arrow-Debreu securities in the two states?

Use the following information for questions Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero. -The firm's expected total value with the investment is

Which of the following statements is are true?

Use the following information for questions Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero. -What is the expected payoff to the bondholders if the project is ndertaken?

If the role of financial intermediaries is to produce and process information, then they are least needed when

With a dissipative signal,

A market is considered complete if

Use the following information for questions Suppose you are a bank lending officer and you are trying to determine if it is worthwhile giving a loan to a potential borrower.You have a prior belief that a borrower is good or bad with equal probability.By gathering information you can determine, albeit imperfectly, whether an applicant is good or bad.If the applicant is good, there is a probability of 0.7 0.3 that your signal reveals that he is good bad.If the applicant is bad, there is a 0.4 0.6 probability that your signal reveals that he is good bad. -What is your posterior belief that an applicant is good when your signal tell you that he is good?

Use the following information for questions . There are two possible states of nature, s = 1, and s = 2, over the next period.There are two securities i and j) whose current prices are $10 and $15, respectively.Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = 2. -If you want to get a payoff of $16 in state s = 1 and $12.8 in state s = 2, how would you allocate your wealth between the two securities i and j?

Moral hazard is a situation where

Use the following information for questions There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $40, a B car is worth $20, and a U car is worth $15.The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale.There is an equal probability of a car being G, B, or U. -Suppose the seller of type G offers a warranty of $g, the type B seller offers $b, and the type U seller offers $u if the car fails.The probability of failure is 0.1, 0.6, and 0.9 for the G, B, and U types, respectively.An incentive compatibility condition is

Suppose there are two risky assets, X and Y, and a riskless bond, B.There are two possible states H and L of the economy over the next period.X provides a payoff of $0 in state H and $50 in state L, while Y provides a payoff of $50 in state H and $0 in state L.B provides a payoff of $50 regardless of the states.X, Y, and B are currently selling for $30, $30, and $25, respectively.A possible riskless arbitrage opportunity is to...

Use the following information for questions There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $40, a B car is worth $20, and a U car is worth $15.The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale.There is an equal probability of a car being G, B, or U. -In equilibrium, which car is offered for sale and at what price?

There are two assets, A and B, with a standard deviation of 10 and 15, respectively.If the correlation coefficient between the two assets is 0.5, then a portfolio that consists of 0.4 of A and 0.6 of B has a standard deviation of

Use the following information for questions Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero. -To maximize the shareholders' wealth, the firm should