Question

Lemons problems arise in capital markets when

1. Managers are better informed about the value of their business ideas than investors
2. Investors cannot distinguish between the good and the bad business ideas.
3. Managers and investors have conflicting interests
4. A, B, and C
5. A and C

Answer 1

Lemon Problem:

The original example for lemon problem was a used car. The question comes why does a seller wants to get rid fo the car? It must be a lemon (waste) is the answer. Now, since the buyer and seller have asymmetric information, the buyer asks for a huge discount considering that the car must be a lemon.

In Finance:

Lemon problem is due to asymmetric information in investing world. In trading/investment, the seller is selling a security/instrument thinking it of a lemon and the opposite side, the buyer is taking the risk that the newly bought instrument. Hence, buyers asks for a huge discount than the price which would be there in a symmetric market.

Sentence 1:

Here, we can notice that managers do have extra information how their business is performing while the investors don;t have those intricate details, Hence we have asymmetric information. Hence this is true for a lemon problem

Sentence 2:

Investors are smart people, who can do valuation for a good or bad business. There are multiple analysis ways and forums to know and distinguish a good and a bad business. Hence, this statement is NOT good for a lemon problem

Sentence 3:

Yes this hold true for a lemon problem. Managers wants to take more risk because their salaries are dependent on the commission basis while an investor is concerned about own profit. Hence, we see a conflict of interest and hence different opinions and asymmetric information.

Hence correct statements are A and C, which is Option E)