Question

Firms with safe and risky projects exist in equal numbers. A safe investment of $100 turns into $110 with certainty. A risky investment is equally likely to turn $100 into $216 or $0. Everyone is risk-neutral and the risk-free rate is 7 percent. Start by assuming symmetric information.

A.) Is the safe project efficient? Is the risky project efficient?

B.) Does the market for safe bonds exist? Does the market for risky bonds exist?

C.) In equilibrium, putting $100 into safe bonds buys how much face value? How about risky bonds?

D.) How much expected profit do firms earn in equilibrium?

E.) Is the equilibrium efficient? Explain.

Now assume asymmetric information.

F.) How much face value do bonds have to offer in order to sell $100 worth of bonds from a pool of safe and risky bonds?

G.) In the equilibrium with asymmetric information, do safe projects receive funding? How about risky projects? Explain.

H.) There are 60 safe and 60 risky projects, and each project costs $800,000. Compute the deadweight loss.

Answer 1

A) The return on a prjoject that is a 'safe' project is quite less. The real rate of return is estimated after deducting inflation from the nominal return that turns out to be negative when a safe project is to be considered. A risk neutral firm can rather choose a risky project considering the high returns that it offers. Thus, based on the assumption that firms are risk neutral, a risky project is efficient.

B) Markets for both risky and safe bonds exist, since individuals are both risk neutral as well as risk averse.

C) Face value of the safe bond = 106% on $100 that is, $106 (6% rate of return).

The rate of return on risky bonds varies based on the risk percentage of the bond.

D) Firms earn ZERO economic profits when there is equilibrium in the market.

(Such number of multiple parts are not to be posted altogether, kindly post the other parts separately. I have answered the first four, hope it helps!)