1.

Typically, borrowers have superior information relative to lenders about the potential
returns and risks associated with an investment project. The difference in information
is called
A) moral selection.
B) risk sharing.
C) asymmetric information.
D) adverse hazard
Answer: C
Explanation: Asymmetric information refers to a situation where one party in a transaction
(in this case, borrowers) possesses more information or has better knowledge about a
particular aspect of the transaction, such as the potential returns and risks of an investment
project, than the other party (lenders).
2. Increasing the amount of information available to investors helps to reduce the
problems of ________ and ________ in the financial markets.
A) adverse selection; moral hazard
B) adverse selection; risk sharing
C) moral hazard; transactions costs
D) adverse selection; economies of scale
Answer: A
Explanation: Increasing the amount of information available to investors in financial
markets helps reduce the problems of adverse selection (occurs before a transaction when
one party has more information than the other) and moral hazard (occurs after a transaction
when one party may take on more risk because of asymmetric information).
3. The ʺlemons problemʺ exists because of
A) transactions costs.
B) economies of scale.
C) rational expectations.
D) asymmetric information.
Answer: D
Explanation: The "lemons problem" is a term used in economics to describe a situation
where there is asymmetric information between buyers and sellers. In such a scenario,
buyers cannot accurately assess the quality of a product or service being offered, leading to
a market where lower-quality goods tend to dominate because buyers are hesitant to pay a
premium price when they cannot determine the true quality. Asymmetric information,
where one party (usually the seller) has more information than the other (usually the buyer),
is the root cause of the lemons problem.
4. Because of the ʺlemons problemʺ the price a buyer of a used car pays is
A) equal to the price of a lemon.
B) less than the price of a lemon.
C) equal to the price of a peach.
D) between the price of a lemon and a peach.
Answer: D
Explanation: In the context of the "lemons problem" and the used car market, buyers are
often willing to pay a price that falls somewhere between the price of a "lemon" (a low-
quality, defective car) and the price of a "peach" (a high-quality, well-maintained car). This
is because buyers cannot fully distinguish between the quality of the cars being sold due to
asymmetric information, so they tend to offer a price that reflects their uncertainty. As a
result, the price paid for a used car is typically in a range between the price of a lemon and
a peach.
5. In the bond market, the bond demanders are the ________ and the bond suppliers are
the________.
A) lenders; borrowers
B) lenders; advancers
C) borrowers; lenders
D) borrowers; advancers
Answer: A
In the bond market, the bond demanders are typically lenders (investors or buyers of
bonds), and the bond suppliers are borrowers (entities issuing bonds to raise capital).
Lenders provide funds by purchasing bonds from borrowers.
6. The free-rider problem occurs because
A) people who pay for information use it freely.
B) people who do not pay for information use it.
C) information can never be sold at any price.
D) it is never profitable to produce information.
Answer: B
Explanation: The free-rider problem occurs when individuals or entities benefit from a
resource, service, or information without directly paying for it or contributing to its costs.
In the context of information, it means that people can access and use information without
having to bear the costs associated with its production or dissemination. This can create
challenges in situations where the costs of producing and sharing information are not fully
covered by those who benefit from it.
7. Net worth can perform a similar role to ________.
A) diversification
B) collateral
C) intermediation
D) economies of scale
Answer: B
Explanation: Net worth can perform a similar role to collateral in financial transactions.
Collateral is an asset that a borrower pledges as security for a loan, and if the borrower
defaults on the loan, the lender can take possession of the collateral. Similarly, a borrower's
net worth represents their assets minus their liabilities, and it can serve as a form of financial
security or assurance for lenders. In case of default, a lender may have a claim on the
 borrower's net worth or assets. This helps reduce the lender's risk and encourages lending,
similar to how collateral does.
8. A conflict of interest can occur for accounting firms when the firms both
A) provide auditing services and non-audit consulting services.
B) provide non-audit services and tax advice.
C) enter data and record data.
D) monitor data and underwrite securities.
Answer: A
Explanation: A conflict of interest can arise for accounting firms when they provide both
auditing services and non-audit consulting services to the same client. This situation can
create a conflict because the firm might prioritize the interests of its consulting services,
which are more profitable, over its auditing responsibilities, potentially compromising the
objectivity and independence required for effective auditing. To address this concern,
regulations often restrict the types of non-audit services that can be provided to audit clients
to minimize conflicts of interest.
9. Provisions in loan contracts that prohibit borrowers from engaging in specified risky
activities are called
A) proscription bonds.
B) restrictive covenants.
C) due-on-sale clauses.
D) liens.
Answer: B
Explanation: Restrictive covenants in loan contracts are provisions that prohibit borrowers
from engaging in specified risky activities to protect the interests of the lender and reduce
the risk of default.

10. Newly-issued high-yield bonds rated below investment grade by the bond-rating
agencies are frequently referred to as
A) municipal bonds.
B) Yankee bonds.
C) ʺfallen angels.ʺ
D) junk bonds.
Answer: D
Explanation: Newly-issued high-yield bonds rated below investment grade by bond-rating
agencies are commonly referred to as "junk bonds" because they are considered riskier
investments due to their lower credit ratings.