Consider the example in Figure 7.2 with asymmetric information: the two firms know which one is risky
Question:
In Figure 7.2
a. The risky firm's project earns $150 with probability 3/4, and zero with probability 1/4.
b. The risky firm's project earns $150 with probability 4/5, and zero with probability 1/5.
Transcribed Image Text:
(A) ASSUMPTIONS Savers . Firm must sell bond Firm must sell bond toWill buy bonds for $100 to finance project that costs S100. Project earns $125 forProject earns $150 finance project that costs $100. if expected payment is at least $110. with 2/3 probability $0 with 1/3 probability. sure. -Firm defaults on bond if So earnings. Expected payment on bond is thus 2/3 of promised payment. (B) WITH SYMMETRIC INFORMATION (C) WITH ASYMMETRIC INFORMATION Savers .Sells bond that eSavers require e If both firms issue bonds, average promised payment of $165 to get expected payment of $110 probability of payment is 5/6 (average of 1 and 2/3). pays $110. Earns profit of $125-$110 $15. (2/3 x $165 $110) Savers require promised payment of $132 to get expected payment of $110 (5/6 x $132 $110). .$165 exceeds highest possible earnings of $150, so firm abandons project. Savers buy bond Safe Firm Risky Firm $132 exceeds earnings of $125, so firm abandons project Will issue bond: has 2/3 chance of earning $150 for profit of $150--$132 No bond issued $18. Savers No bond issued Require promised payment of $165 because probability of payment is 2/3. No bond issued
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