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Unformatted text preview: ransaction costs and asymmetric information Functions of Financial Intermediaries
Functions of Financial Intermediaries
► 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. ► 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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This document was uploaded on 03/14/2014.
- Spring '14
- Financial Markets