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Unformatted text preview: Chapter 7: Asymmetric Information in the Financial System 7.1: Adverse Selection Adverse selection among the informed parties, those who are most eater to make a deal are the least desirable parties on the other side (but most likely get the loan) o The lemons problem Lemons vs. peaches (see notes) o Lemons in securities markets Lemons in stock markets firms know if their stock is undervalued and often issue more undervalued stock to customers Lemons in bond markets adverse selection is not always a problem when issuing bonds o Adverse selection: a numerical example Assumptions: 2 firms have potential investment projects Each project costs $100 to undertake One firms project is safe and produces $125 revenue for sure The other firms project is risky and has a 2/3 probability of producing $150 and a 1/3 probability of producing $0. o For this firm the expected revenue ( for sure) is 2/3 ($150) = $100 Savers will accept the project if the expected payment/revenue is at least $110 Expected PMT from a bond = (promised PMT) x (probability of project success) Symmetric information (using above assumptions) Savers know if a project is risky or safe and would not take the risky project b/c $100 &lt; $110 Asymmetric information (using above assumptions) Savers will drive up the promised PMT higher and higher until the risky firm is driven out of the market, AND neither firm issues bonds in the end 7.2: Moral Hazard Moral hazard harmful behavior after the transaction on the part of the firm/saver Principal-agent problem...
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- Summer '08