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Chapter 4 - Financial Markets

Reducetransactioncostsbydeveloping

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Unformatted text preview: ransaction costs and asymmetric information Functions of Financial Intermediaries Functions of Financial Intermediaries Transaction costs ► Financial intermediaries make profits by reducing transaction costs 1. ► Reduce transaction costs by developing expertise and taking advantage of economies of scale Asymmetric information ► the inequality of knowledge that each party to a transaction has about the other party 2. 2. ► Consists of 2 types: Adverse selection and, Moral hazard Adverse selection: 1. Before transaction occurs ► 2. Potential borrowers most to produce adverse outcome are ones most likely to seek loan and be selected E.g. a person who is unhealthy would actively seek insurance policy to cover his medical expenses. Moral hazard 1. After transaction occurs ► 2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back E.g. after getting a loan, the borrower used the money for some undesirable activities instead of for the business ► Without financial intermediaries, it is impossible for borrowers and lenders to engage in transactions ► Financial intermediaries reduce adverse selection and moral hazard problem, enabling them to make profits...
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