Introduction to Finance

Topics: Information asymmetry, Principal-agent problem, Asymmetric information Pages: 5 (1779 words) Published: April 4, 2013

[Introduction to Finance]

Student Particulars

IC Number| | 890909-14-6640|
Student Number| | SC-KL-00037505|
Subject Title| | Introduction to Finance|
Subject Code| | |
Mode of Study| | Full-Time Part-Time Independent Learning E-Learning| Name of Lecturer| | Mr Terrence Tan|
Due Date| | 20/02/2013|
Declaration by student:I, NIRSHEILA SHAM KAUR A/P SHAMSHER SINGH, hereby declare that the attached assignment is my own work and understand that if I am suspected of plagiarism or another form of cheating; my work will be referred to the Programme Director who may, as a result recommend to the Examinations Board that my enrolment in the programme be discontinued.Acknowledgement of receipt_________________________Date ReceivedSignature of Receiving Officer|

A) Difference of Principal and Agent
An agency trade is when a firm buys or sells a security on behalf of a client to a third party. They will usually collect a commission for this service. During this transaction the firm does not own the security itself. A principal trade is when a firm buys or sells securities from their own account. Anytime the firm is buying or selling from within their own inventories, it is a principal trade. The principal is able to observe a certain outcome, produced by the combination of the level of effort exerted by the agent and the occurrence of a certain state of nature (referring to some exogenous variables that influence productivity levels but lie beyond the control of the agent), but differ in the amount of information available to the principal. The models also generally assume the agent is not very keen on taking risks. When offered the choice between a contract with a fixed fee and a contract with a variable pay that yields the same average height (lower than the fixed fee in case of an unfortunate outcome and higher in case of a good outcome), the agent will always opt for the certainty of the former. He can only be persuaded to opt for the latter when the average compensation level is significantly higher than the one under the fixed-fee contract. In other words, the agent is assumed to be risk averse. The principal, on the other hand, is generally assumed to be risk-neutral. Within the symmetric information model, it is assumed that the information possessed by the agent is also known to the principal. In other words, the principal is perfectly informed as to the character of his agent and is able to observe the effort exerted on the task. In such case, Levinthal (1988) and Perloff (2003) show that the principal can elaborate a contract that is optimal for both the agent and himself (a first-best solution) by founding the compensation schemes upon the exerted effort levels. By attaching the highest net utility (utility from income minus disutility from effort) to the effort level most desired by the principal, a utility-maximizing agent can always be persuaded to dedicate the level of effort preferred by the principal. Since income is contingent only on the effort level and is independent of the state of nature and of the realized outcome, the agent will also not be forced to bear any unnecessary risk. A first-best solution will be obtained. Within the asymmetric information model, the informational symmetry between principal and agent is destabilized by the introduction of moral hazard or adverse selection. Moral hazard refers to the fact that the exact level of effort the agent dedicates to her task can be cloaked, leaving the principal to make an educated guess about his contractual counterpart’s true efforts. The agent, however, will always know how much effort she dedicates to her task. Adverse selection, on the other hand, refers to the fact that the principal is unable to observe relevant...
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