How does asymmetric information affect the default premium and the

How does asymmetric information affect the default premium and the firm’s investment choice?

A. Banks must charge all borrowers a higher interest rate on loans in order to ensure they are able to pay depositors a promised rate of return. This is due to asymmetric information and the uncertainty of the borrower’s ability to pay back the loan. The amount of additional interest charged to lenders above the rate that would be charged to an ideal borrower is referred to as the default premium. By doing this, the default premium charged to good borrowers will compensate the bank for loans made to bad borrowers. The size of the default premium can then influence afirm’s investment choice.

B. Banks don’t have perfect information about borrowers, so they will incentivize borrowers to pay back their loans in a timely manner by offering a financial reward. This reward, referred to as the default premium, is typically structured by offering the borrower a small portion of the loan without need for repayment, on the condition that the remainder of the loan amount is paid on schedule. This incentivizes firms with good borrowing practices to invest more.

C. Banks will charge a higher interest rate on loans to certain borrowers that are deemed risky. The amount of additional interest charged to the risky borrowers above the real interest rate is referred to as the default premium. Because of asymmetricinformation, banks are more cautious and will sometimes charge default premiums to firms that are actually good borrowers. This can impact the investment choice for firms that are good borrowers because they might need to pay an unfair interest rate.

D. Banks pass the burden of bad loans and recovery of payment to the government. Because asymmetric information prevents identifying bad borrowers, the government must account for this burden by raising corporate taxes when the default rate increases. The additional increase in corporate tax rates based on default rates is referred to as the default premium. When the default premium is high, firms are taxed at a higher rate, and investment will likely decrease.