Question

Because of the adverse selection problem in the financial market, a firm’s newly issued stocks or bonds could be ( ) so that the firm would withdraw from the market. It will leave only the ( ) credit firms in the market.

Words:

Good, bad, undervalued, overvalued

Answer 1

Adverse Selection problem occurs when there is information asymmetry in the market. One part has more information than other party. It occurs before the transaction takes place.

It is very difficult for the owners of the firm to distinguish between a firm with good prospects and a firm with bad prospects. In such case, the stocks of good firms are undervalued so that the owners of the firm can keep these stocks away from the market.

Such an action would leave only the bad credit firms in the market with higher risk of default.

Hence, Undervalued and Bad are the correct choices.

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