Understanding Adverse Selection

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Clara Rodriguez
Assignment 1

Assignment 1

1. Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.


Adverse selection- this is a condition which acknowledges that people with more risky project are more likely to ask for loans and there is an information asymmetry present. To reduce the risks associated with adverse selection risk evaluation needs to be as accurate as possible and screening for services successful.

Moral hazard- this refers to a situation where one party is more informed than the other party. This can be applied to a loan; the bank is not sure whether the money will be used for what the loan intends, only the borrower will be mindful of the purpose for the loan, and therefore has an a symmetrical information advantage over the lender. This problem can be reduced by limiting the amount of risk associated with lending agreements from the perspective of the lender and borrower, ensuring that the borrowed funds not be used recklessly.

2. Which of the following three expressions uses the economists; definition of money? Provide an explanation,

- “How much money did you earn last week?
- “when I go to the store, I always make sure I have enough money”
- The love of money is the root of all evil

Economists define money as anything that is accepted as a means of payment for goods and services, or in the repayment of debt (Mishkin, 49). The second statement listed above references payment for goods and services, which is the inherent condition for the given definition. The first and third statements listed reference money in a figurative existence. The first option references a rough quantitative number, which generally would ignore the benefits from the health insurance and company picnic and the third statement refers to behavior as a result of fantasy.

3. For each of the following assets, indicate which of the money aggregates (M1 and M2) includes them:
- Currency- M1
- Money market and mutual funds- M2
-Small denomination time deposits- M2
- Checkable deposits- M1

4. If the interest rate is 5%, what is the present value of a security that pays you $1,050 next year and $1,102.50 two years from now, if this security is sold for $2200, is the yield to maturity greater or less than 5%? Why?

PV =1050(1.05) + 1,102.50(1.05)2 = 2000.00
The yield to maturity equates the present value of cash flow payments received from a debt instrument with its value today. The yield to maturity is greater than 5% because the present value of the cash flows ($2000) is less than the sale price ($2200).

I think this is incorrect:
2200 = 1050(1+i) + 1,102.50(1+i)2, i= negative??
The yield to maturity is less than five percent.

5. Assume you just deposited $1,000 into a bank account. The current real interest rate is 2% and inflation is expected to be 6% over the next year. What nominal interest rate would you require from the bank over the next year? How much money will you have at the end of the year?

The fisher equation states that nominal interest rate equals real interest rate plus inflation. This would lead to a required 8% nominal interest rate and a yearend balance of $1,080.00.

6. A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for $871.65. Compute your rate of return if you sell the bond next year for $880.10.

In general, return = R = Coupon+Pt+1 (sale)- Ptpt = 70.+ 880.10 - 871.65871.65 = 0.090002 = 9.00 %

7. Using both the liquidity preference framework and the supply and demand for bonds frameworks, show why interest rates are procyclical (rising when the economy is expanding and falling during recession). Provide a figure(s) to illustrate you answer.

SUPPLY AND DEMAND FOR BONDS FRAMEWORK: determines interest rate in...
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