Financial Question in issuance bond and stocks

Business & Finance
Tutor: None Selected Time limit: 1 Day

Starting in the 1980's, there has been a large increase in the issuance of bonds relative to issuance of stock by corporations.  Explain why this might be a response of stockholders to the moral hazard associated with the principal-agent problem.

Nov 11th, 2014

In economicsmoral hazard occurs when one person takes more risks because someone else has agreed to bear the burden of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

Moral hazard occurs under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

For example, with respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain their payments in the long run and that, for this reason, the loans were not going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans. After selling the loans, the originators bore none of the risk so there was little to no incentive for the originators to investigate the long-term value of the loans. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.

Another, more complex, example would be the euro debt crisis, in which the troika of relief funds (aka the ECB, the IMF, and the EC) for heavily indebted nations like Greece[1]are waiting as long as possible to act. The risks of a money run, and the consequential market crash in Europe is by far not as detrimental to these institutions as to the indebted nations themselves.


Nov 11th, 2014

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