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 5 percent?
b. Would this market function well? What type of asymmetric information problem does this example illustrate?