The problem of moral hazard
A) is considerably more serious when an investor buys a firm's bonds than when the investor buys a firm's stock.
B) is considerably more serious when an investor buys a firm's stock than when the investor buys a firm's bonds.
C) is equally serious whether an investor buys a firm's bonds or a firm's stock.
D) is nonexistent for investors who buy corporate bonds or stock.

Question

Quizplus · Accepted Answer

Moral hazard refers to the risk that an individual may take more risk or act in a reckless manner because the potential cost of failure is borne by another party. In the case of buying a firm's bonds, the investor is a lender who receives a fixed income and has a contractual right to be repaid. Hence, the firm has less incentive to take excessive risk as they have a legal obligation to repay the debt. On the other hand, buying a firm's stock implies ownership and a share in the company's profits and losses. The firm may have an incentive to take on excessive risk to increase profits, which could potentially harm the stockholders. Therefore, the moral hazard problem is considerably more serious when an investor buys a firm's stock than when they buy a firm's bonds.

The Problem of Moral Hazard