Consider the example in Figure 7.2 with asymmetric information: the two firms know which one is risky and which is safe, but savers do not. Keep the example the same as in the figure, except for the earnings of the risky firm. For the following cases, say whether the safe firm can sell a bond and whether the risky firm can sell a bond.
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.

(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