Asymmetric Information.

Topics: Debt, Loan, Moral hazard Pages: 5 (1399 words) Published: December 2, 2014
 Presentation Number 8 ROLL NO.26

Asymmetric Information can be defined as "information that is known to one party in a transaction but no to the other party". The classified argument is that some sellers with inside information about the quality of an asset will be unwilling to accept the terms offered by a less informed buyer. This may cause the market breakdown or at a price lower than it would command if all buyers and sellers had full information. This is known as lemon market problem in valuation. This concept has been applied to both equity and debt finance.

Equity Finance: For equity finance, shareholders demand a premium to purchase shares of relatively good firms to offset the losses arising from funding lemons. This premium raises the cost of new equity finance faced by managers of relatively high quality firms above the opportunity cost of internal finance faced by existing shareholders.

Debt Finance: In debt market, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked. The lender on the other side does not have sufficient information concerning the borrower. Lack of sufficient information creates problems before and after the transaction entered into, which is potentially a major problem with Islamic profit sharing financial contracts. The presence of asymmetric information normally leads to adverse selection and moral hazard problems.

1) Adverse Selection:
Adverse selection refers to a situation in which sellers have relevant information that buyers lack or buyers have relevant information that sellers lack about some aspect of product quality. The term refers to the problem created by asymmetric information before the transaction occurs. It occurs when the potential borrowers are the one most likely to produce an adverse outcome. Bad credit risks are the ones who most actively seek out a loan and thus are most likely to be selected.

2) Moral Hazard:
Moral hazard is the consequence of asymmetric information after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lenders point of view because they make it less likely that borrower will repay the loan. The conventional debt contract is a contractual agreement by borrower to pay the lender a fixed amount of money at periodic intervals. When the firm has high profits lender receives the contractual payment and does not need to know the exact profits of the borrower. If the managers are pursuing activities that do not increase the profitability of the firm the lender does not care as long as the activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm can not meet its debt payments, thereby being in a state of default there is a need for the lender to verify the state of the firm profits.

Key difference: before versus after the deal
Adverse selection: asymmetry in information prior to the deal Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece. It is this asymmetry of information prior to the transaction that prevents the transaction from occurring. If both the seller and the buyer were uncertain of the quality, they would be willing to trade the good based on...
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