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Level 41

Information Asymmetry & Market Efficiency

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Two groups of people where one party knows more than the other
Adverse Selection
This happens before the transaction
moral hazard
the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view
Combat adverse selection
Private Production and Sale of Information
Private Production and Sale of Information
Private companies collect and produce information that distinguishes good from bad firms and then sell information to investors
Government Regulation to Increase Information
The financial system is among the most heavily regulated sectors of economy
Financial Intermediation
Solves adverse selection in a manner similar to how used car dealers solve lemons problem in used car market
Collateral and Net Worth
Address the consequence of adverse selection: if borrower defaults, lender suffers a loss
Combat moral hazard- EQUITY
Production of Information: Monitoring
Production of Information: Monitoring
Stockholder's monitor firms activities
Debt Contracts
Reduce need to monitor managers
Combat moral hazard- DEBT
Net worth and collateral
Net worth and collateral
If value of net worth or collateral is high, borrower has more to lose in the event of default
restrictive covenants
long legal documents with provisions that restrict and specify certain activities that the borrower can engage in
Why regulate financial system?
Increase informations to investors- reduce adverse selection and moral hazard
Weak Form
Stock prices reflect all past market price and volume information
Semi-strong Form
Stock prices reflect all publicly available information about a firm
Strong Form
Stock prices reflect ALL information about the firm (private and public)