Asymmetric Information

Issues in Modern Finance

Adverse Selection
Moral Hazard
Principle-Agent Problem

Market Efficiency

Problems Arising from

Asymmetric Information

Problems Arising from

Asymmetric Information
Adverse selection

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction

Moral hazard

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction

Moral hazard
Occurs after a market transaction

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction

Moral hazard
Occurs after a market transaction

Principal-agent problem
A variant of moral hazard

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an
uninformed party gets exactly the wrong
people wanting to trade with her; there
is an adverse selection of the (better
informed) possible trading partners

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an
uninformed party gets exactly the wrong
people wanting to trade with her; there is an
adverse selection of the (better informed)
possible trading partners
Examples
Used car market (which gives rise to another term
for adverse selectionthe lemons problem)

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an
uninformed party gets exactly the wrong
people wanting to trade with her; there is an
adverse selection of the (better informed)
possible trading partners
Examples
Used car market (which gives rise to another term
for adverse selectionthe lemons problem)
Market for insurance

Problems Arising from

Asymmetric Information

Adverse selection

Occurs prior to a market transaction

Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of
the (better informed) possible trading partners
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)
Market for insurance
Market for credit

Problems Arising from

Asymmetric Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of
the (better informed) possible trading partners
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)
Market for insurance
Market for credit
Sale of securities

The Lemons Problem: How Adverse Selection

Influences Financial Structure

Lemons Problem in Securities Markets

1. If we can't distinguish between good and
bad securities, willing pay only average
of good and bad securities value
2. Result: Good securities undervalued and
firms won't issue them; bad securities
overvalued so too many issued

Remedies for Adverse

Selection
Market screeningprocess by which
an uninformed party attempts to
gather information about the product
or service offered by the informed
party

Remedies for Adverse

Selection
Market screeningprocess by which
an uninformed party attempts to
gather information about the product
or service offered by the informed
party
Examples

Remedies for Adverse

Selection
Market screeningprocess by which
an uninformed party attempts to
gather information about the product
or service offered by the informed
party
Examples
Audits

Remedies for Adverse

Selection
Market screeningprocess by which
an uninformed party attempts to
gather information about the product
or service offered by the informed
party
Examples
Audits
Regulation

Remedies for Adverse

Selection
Market screeningprocess by which
an uninformed party attempts to
gather information about the product
or service offered by the informed
party
Examples
Audits
Regulation
Financial Intermediation

Remedies for Adverse

Selection
Market signaling

Remedies for Adverse

Selection
Market signalingprocess by which
an informed party sends signals to
uninformed parties conveying
information about the quality of the
product or service theyre trying to
sell

Remedies for Adverse

Selection
Market signalingprocess by which
an informed party sends signals to
uninformed parties conveying
information about the quality of the
product or service theyre trying to
sell
Signal must be effective in
distinguishing between different
levels of quality

Remedies for Adverse

Selection
Market signalingprocess by which an
informed party sends signals to
uninformed parties conveying information
about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer

Remedies for Adverse

Selection
Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the
quality of the product or service theyre
trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples

Remedies for Adverse

Selection
Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the
quality of the product or service theyre
trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples
Education

Remedies for Adverse

Selection
Market signalingprocess by which an informed
party sends signals to uninformed parties
conveying information about the quality of the
product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples
Education
Guarantees and warranties

Remedies for Adverse

Selection
Market signalingprocess by which an informed
party sends signals to uninformed parties
conveying information about the quality of the
product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples
Education
Guarantees and warranties
Signals on the job

Remedies for Adverse

Selection
Market signalingprocess by which an informed
party sends signals to uninformed parties
conveying information about the quality of the
product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples

Education
Guarantees and warranties
Signals on the job
Reputation

Remedies for Adverse

Selection
Market signalingprocess by which an informed party
sends signals to uninformed parties conveying
information about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing between
different levels of quality
Signal will be more costly for a low-quality producer
than for a high-quality producer
Examples

Education
Guarantees and warranties
Signals on the job
Reputation
Gifts

Remedies for Adverse

Selection
Market signalingprocess by which an informed party
sends signals to uninformed parties conveying information
about the quality of the product or service theyre trying to
sell
Signal must be effective in distinguishing between different
levels of quality
Signal will be more costly for a low-quality producer than
for a high-quality producer
Examples

Education
Guarantees and warranties
Signals on the job
Reputation
Gifts
Beating analyst expectations

Problems Arising from

Asymmetric Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a
transaction to change peoples
incentives and therefore their behavior

Problems Arising from

Asymmetric Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a
transaction to change peoples
incentives and therefore their behavior
Examples

Problems Arising from

Asymmetric Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a
transaction to change peoples
incentives and therefore their behavior
Examples
Insurance market

Problems Arising from

Asymmetric Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a
transaction to change peoples
incentives and therefore their behavior
Examples
Insurance market
Banking

Principal-agent problem
Principal-agent problem
A variant of moral hazard

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principalagent problem
(1) Asymmetric informationit must
be difficult
or costly for the principal to
monitor the
actions of the agent

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent
(2) Divergent interestsprincipal and agent
must
have different interests or goals

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent
(2) Divergent interestsprincipal and agent must
have different interests or goals
Examples and Remedies

Financial Markets and the Economy

Separation of Ownership and Management
Agency problems arise when managers start
pursuing their own interests instead of
maximizing firm's value

Mechanisms to mitigate agency problems:

Tie managers' income to the success of the firm
(stock options)
Monitoring from the board of directors
Monitoring from the large outside investors and
security analysts
Takeover threat

Financial Markets and the Economy

Corporate Governance and Corporate
Ethics
Accounting Scandals
Examples Enron, Rite Aid, HealthSouth

Auditors: Watchdogs of the firms

Analyst Scandals
Arthur Andersen

Sarbanes-Oxley Act
Tighten the rules of corporate governance

The Investment Process

Portfolio: Collection of investment
assets.
Asset allocation
Choice among broad asset classes

Security selection
Choice of securities within each asset
class

The Investment Process

Top-down approach
Asset allocation followed by security
analysis to evaluate which particular
securities to be included in the portfolio

Bottom-up approach
Investment based solely on the priceattractiveness, which may result in
unintended heavy weight of a portfolio in
only one or another sector of the economy

Markets Are Competitive

Risk-Return Trade-Off
Higher-risk assets are priced to offer
higher expected returns than lower-risk
assets

Efficient Markets
In fully efficient markets when prices
quickly adjust to all relevant
information, there should be neither
underpriced nor overpriced securities