Q#1. When a corporation offers shares of stock or other securities to the public, it hires an underwriter to conduct the sale. (The underwriter is an investment bank such as Morgan Stanley or Goldman Sachs.) Most commonly, firms and investment bankers use a procedure known asfirm commitment underwriting. In this arrangement, the underwriter buys the shares from the company and then sells them to the public. If the offering is undersubscribed or if the price must be subsequently lowered to unload the shares, the underwriter, not the firm, suffers the loss.
Why do firms and underwriters use this procedure? What is in it for each? How does this means of sale affect the buying public?
Q#2. Since the mid-1980s, baseball teams have bid vigorously for free agentsplayers with six or more years of service who are free to sign with a new team. After signing a five-year contract with a new team for an exorbitant amount, a free-agent pitcher has had three consecutive lackluster seasons.
a. How might adverse selection explain this outcome?
b. How might moral hazard cause this outcome? Explain.
c. What advice would you give owners in bidding for free agents?