a) Discuss how asymmetric information affects lending/borrowing. (12 marks)
b) Discuss the solutions to the moral hazard problem in debt markets. (13 marks)
a) When the buyer or the seller has more knowledge about an investment's history, current, or future results, asymmetric information may arise in the financial markets. One side is capable of making an educated decision, but the other is not.
The buyer may know that the asset is underpriced, or the seller may know that it is underpriced. In either case, one party has the opportunity to profit from the transaction at the expense of the other.
i) Split up banks so they are not too big to fail;
When banks with consumer deposits often take on risky investments, the issue arises. It is the risky investments that need assistance.
ii) Performance related pay;
There can be some form of performance appraisal and no guarantee of a work for life to prevent moral hazard in the labor market.
iii)Penalise bad behaviour ;
The government could bail out banks while punishing those who made the risky decisions.
iv) Build in incentives;
To prevent moral hazard in insurance, the insurance company will draft a contract that will provide you with a financial incentive to insure your bike.