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BUS 308 Credit Lending Decison

ï¿½QUESTION 1(a) (continued)

((ii) How does the free-rider problem make adverse selection and moral hazard problems worse in financial markets? Did free-rider problem contribute/exacerbate the global financial crisis? Be specific.

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QUESTION 1(b)

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CONBANK bank has the following market valueï¿½balance sheet structure:

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 Assets Liabilities and Equity Cash \$2,000 Certificate of Deposit \$20,000 Bond \$20,000 Equity \$2,000 Total \$22,000 ï¿½ \$22,000

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The bond has a 20-year maturity and fixed-coupon rate of 5 percent. The certificate of deposit has a one-year maturity and a 3 percent fixed rate of interest. SBSC bank expects no additional asset growth.

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(i)ï¿½If at the end of the year one market interest rate decreasedï¿½by 50 basis points, what will be the netï¿½interest income for the second year?

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QUESTION 1(b) (continued)ï¿½

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(ii) Calculate the market value of equity at the end of year one assuming that market interest rates decreasedï¿½by 50 basis points.

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QUESTION 1(c) [ 5 marks]

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Applicants for single period loans of \$1,500,000 at the contracted interest rate of 3.0% per annum (p.a.) have been assessed to a range of default probabilities. The bank can finance these loans at the risk-free rate of 1.25% p.a. What is the cut-off default probability? What implication does this result have for the bankï¿½s screening function?

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Answer
Answers:
The free-rider problem occurs when individuals or firms can benefit from a public good without contributing to its provision. In financial markets, the free-rider problem can exacerbate adverse selection and moral hazard problems.

Adverse selection refers to the problem of asymmetric information, where one party in a transaction has more information than the other, leading to an imbalance of risk. In financial markets, adverse selection can occur when the lender has less information about the borrower's creditworthiness than the borrower. In this case, borrowers who are more likely to default on their loans are more likely to seek out and obtain loans, leaving lenders with a riskier portfolio of loans.

The free-rider problem can make adverse selection worse because potential borrowers who are more likely to default on their loans can obtain financing without contributing to the cost of screening and monitoring their creditworthiness. As a result, lenders are left with a higher proportion of risky borrowers in their portfolio, which can lead to increased defaults and losses.