Question

ECON 315 / Money, Banking and Financial Markets

1. During the financial collapse in the U.S. beginning in 2008, several bond rating agencies were accused of overstating the quality of the assets they were rating. It was also revealed that these agencies had close working relationships with the firms they rated. Briefly explain what sorts of problems arise because of this relationship.

2. Consider the “Five Cs” of business lending. Define three of them and give your own example.

3. Explain the difference between adverse selection, information asymmetry and moral hazard. Describe each and provide at least one example.

4. Describe the Efficient Market Hypothesis. What implications does it have on the market?

Answer 1

In the year 2008, when the ratings agency had close relationship with the firm's they were rating, led to the over rating of the asset. This relationship between them , made the ratings agencies provide higher rating to the assets of the firm, because the aim of the rating agencies was to make money by providing the rating which the firm wanted for itself ,and not the actual rating which it deserved. This higher rating provided a better picture of the firm to the investors and the firms made huge money. This over rating later on ended up with crisis in that year. This relationship led to no transparency, distortion and finally crisis.

The five C' are Capacity, Collateral, Covenant, Capital and character.

Covenant- These are the restrictions or conditions which needs to be fulfilled by the borrower. Example - in case of any legal activity, there are many points written on an agreement , those point are covenant.

Collateral- It is a kind of security which needs to be provided while borrowing. For example at the time of taking loan you mortgage your house.

Capacity- It refers to whether the person will be able to pay back the money he has taken.

Part c)

Adverse selection- It mean that only one party either buyer or seller possess the information . There is lack of symmetry information between the two parties before the deal.

Moral Hazard- When one party among the two possess more material knowledge about a deal and uses the information after the deal is struck, for his benefit . This is moral Hazard.

Information Asymmetry- When one party has more knowledge than other party in a deal is called information Asymmetry .

Part d)

Efficient market hypothesis means that the current price of the stock reflects all the information available in the market and also the private information. When there is efficient market no person can use any information to earn excess profit as the current price of the stock soaks in all the information available.