Suppose two types of firms wish to borrow in the bond market. firms of type a are in good financial health and are relatively low risk. the appropriate premium over the risk-free rate for lending to these firms is 2 percent. firms of type b are in poor financial health and are relatively high risk. the appropriate premium over the risk-free rate for lending to these firms is 6 percent. as an investor, you have no other information about these firms except that type a and type b firms exist in equal numbers.
a. at what interest rate would you be willing to lend if the risk-free rate were 6 percent? investors don't know which type of firm percent.
1 percent, while that for bonds of type b firms would be 12 ▲ percent. since i the appropriate interest rate for bonds of type a firms would be 8 they are dealing with and there is an equal probability of either type of firm, they will only be willing to lend if they receve at least the average rate of click to select
b. would this market function well? what type of asymmetric information problem does this example illustrate? no desirable firms are willing to borrow. type a firms would not be willing to pay this interest rate and so would withdraw from the market. this is an example of an adverse selection problem. only the less