Session 2: Asymmetric Information

Session Learning Outcome
Learners will have an understanding of the influence of holding unequal information of a business firm in decision-making.

Important Learning Terms

• Asymmetric information
• Adverse selection
• Moral hazards

Asymmetric information: Can be defined as information that is known to some people but not to other people.

Information asymmetries can precipitate a difference in the cost of internal and external finance, i.e. making internal net worth more valuable, holding constant investment opportunities (this is a ‘lemon market’ problem in valuation).

The classical argument is that some sellers with inside information about the quality of an asset will be unwilling to accept the terms offered by a less informed buyer. This may cause the market to break down, or at least force the sale of an asset at a price lower than it would command if all buyers and sellers had full information. This idea has been applied to both equity and debt finance.

For equity finance, shareholders demand a premium to purchase shares of relatively good firms to offset the losses arising from funding lemons. This premium raises the cost of new equity finance faced by managers of relatively high-quality firms above the opportunity cost of internal finance faced by existing shareholders.

In debt market, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked. The lender on the other side does not have sufficient information concerning the borrower. Lack of enough information creates problems before and after the transaction is entered into. The presence of asymmetric information normally leads to adverse selection and moral hazards problems.

Information Asymmetry causes two issues worth to discuss.

Adverse Selection
This refers to a situation in which sellers have relevant information that buyers lack (or vice versa) about some aspect of product quality. This is the problem created by asymmetric information before the transaction occurs. It occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome, the bad credit risks, are the ones who most actively seek out a loan and are thus most likely to be selected.

In the simplest case, lenders cannot price discriminate (i.e. vary interest rates) between good and bad borrowers in loan contracts, because the riskiness of projects is unobservable. Thus, when interest rates increase, relatively good borrowers drop out of the market, increasing the probability of default and possibly decreasing lenders’ expected profits. In equilibrium, lenders may set an interest rate that leaves an excess demand for loans. Some borrowers receive loans, while other observationally equivalent borrowers are rationed.

Moral Hazard
Moral hazard is the consequence of asymmetric information after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back. The debt contract is a contractual agreement by the borrower to pay the lender a fixed amount of money at periodic intervals. When the firm has high profits, the lender receives the contractual payments and does not need to know the exact profits of the borrower. If the managers are pursuing activities that do not increase profitability of the firm, the lender does not care as long as the activities do not interfere with the ability of the firm to make its debt payments on time. Only when the firm cannot meet its debt payments, thereby being in a state of default, is there a need for the lender to verify the state of the firm’s profits.