Question

In: Economics

(a) Why is indirect finance, relative to direct finance, more widely used for channelling funds? (15...

(a) Why is indirect finance, relative to direct finance, more widely used for channelling funds?

(b) How does the moral hazard affect the choice between debt and equity contracts? How does a debt contract reduce the problem of moral hazard?

Solutions

Expert Solution

a) In indirect finance, an investor borrows and invests through intermediary channels while in direct finance, the investor deals directly with the financial company. For example, an individual will prefer to invest in a mutual fund instead of stock of a company. This is because the individual is not well equipped to take the risks of directly investing in the stock, but the intermediaries can. Sometimes, there is a minimum investment requirement and the individual may not have so much indirectly. Also, indirect finance helps an individual to diversify risk rather than putting all his eggs in one basket. Also, some direct investments may be very long term, which an individual may be unwilling to undertake. Indirect finance enables them to pool funds and diversify risk.

b) In debt contract a party lends funds to a company that has to be repaid within a cetain period of time while in equity contract, a party owns the funds of a company and has direct stake in the profits of the company. In debt contract, the owner has to be repaid a fixed amount while in equity contract, the party is paid a share of profits. The party can't monitor the effort of the managers of the company and may bear a loss in equity finance due to mismanagement by the company as part of the risk is shifted on the party. This leads to the problem of moral hazard in equity finance for the party. In debt contract the party receives the fixed amount even if the company makes losses. So the entire risk is borne by the company in debt finance solving the problem of moral hazard


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