Question

1 a. Discuss how moral hazard influences the financial structure of the bond markets and outline three (3) ways of dealing with the situation    

b. Discuss how the following functions by players in the financial markets could breed conflict of interest suggest ways of managing the conflict in each case.  

i. Underwriting and Research by same Investment Banking

ii. auditing and consulting by the same accounting firm

iii. auditing and consulting by the same accounting firm

Answer 1

A) Debt (bond market) is still to moral hazard. In fact, debt may create an incentive to take on very risky projects. This is important to understand. Let’s looks at a simple example. Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount. For example, what if a firm owes $100 in interest, but only has $90? It is essentially bankrupt. The firm “has nothing to lose” by looking for “risky” projects to raise the needed cash.

ways to deal with it-

1. Keeping collateral and check on net worth.

2. Financial intermediation by regulatory bodies

3. Monitoring and enforcements of restrictive covanents.

B) i) Research is expected to be unbiased and accurate, reflecting the facts about the firm. It is used by the public to form investment choices. Underwriters will have an easier time if research is positive. Underwriters can better serve the firm going public if the firm’s outlook is optimistic. Underwriters can command a better price for securities issued by a firm if the firm’s outlook is optimistic. An investment bank acting as both a researcher and underwriter of securities for companies clearly has a conflict—serve the interest of the issuing firm or the public.

ii) Auditors check the assets and books of a firm for the quality and accuracy of the information. The objective is an unbiased opinion of the firm’s financial health. Consultants, for a fee, help firms with variety of managerial, strategic, and operational projects. An auditor acting as both an auditor and consultant for a firm clearly is not objective, especially if the consulting fees exceed the auditing fees.

3rd part is same as the 2nd part.