Debt contracts are still subject to ________ because borrowers may take on excessive risk.

Question

BlackTom AI · Accepted Answer

Moral hazard arises when one party to a contract can take unobservable actions that shift risk onto the other party, so borrowers may take on excessive risk after receiving funds.

1. Relevant knowledge points and concepts
- Asymmetric information: one party has private information or can take hidden actions.
- Moral hazard: hidden actions after a contract that alter risk allocation (an agency problem).
- Adverse selection (the lemons problem): hidden characteristics before a contract.
- Limited liability and debt contracts: debt holders get fixed payments while borrowers keep upside, creating incentives to risk-shift.

2. Step-by-step reasoning
- Debt contracts require a fixed repayment to the lender; any residual upside accrues to the borrower.
- After borrowing, the borrower chooses a project. If the borrower can take actions that increase variance (riskier projects), the borrower benefits more from the upside while the lender bears more downside.
- Because the borrower’s downside is limited (they default but often do not repay more than the firm value), the borrower may prefer riskier projects even when those lower expected returns for lenders.

3. Numerical illustration (intermediate steps)
- Borrower receives $100 and must repay $110.
- Safe project: certain return $120 → borrower’s payoff = 120 − 110 = $10.
- Risky project: 50% chance $200, 50% chance $0.
  - If success: borrower gets 200 − 110 = $90.
  - If failure: borrower gets 0 (limited liability).
  - Expected borrower payoff = 0.5×90 + 0.5×0 = $45, which exceeds $10, so borrower prefers risky project even if lender’s expected repayment falls. This is moral hazard.

4. Why the correct answer is correct
- The example and incentive analysis show the borrower has an incentive to take excessive risk after the debt contract is in place; that is the textbook definition of moral hazard.

5. Why other options are incorrect
- a. The lemons problem (adverse selection) is about hidden quality before contracting, not hidden actions afterward.
- b. Diversification is a risk-reduction strategy, not a problem caused by borrowers.
- c. Agency theory is a broad framework describing principal-agent problems; moral hazard is the specific agency problem relevant here. The best, specific answer is moral hazard.

Conclusion: The correct choice is d. moral hazard, which matches the provided answer.

Debt contracts are still subject to ________ because borrowers may take on excessive risk.Single choice

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