Suppose two types of fi rms wish to borrow in the bond market. Firms of type A are in good fi nancial health and are relatively low risk. The appropriate premium over the risk-free rate of lending to these fi rms is 2 percent. Firms of type B are in poor fi nancial health and are relatively high risk. The appropriate premium over the risk-free rate of lending to these fi rms is 6 percent. As an investor, you have no other information about these fi rms except that type A and type B fi rms 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?