Question

2. What happens in a market when one side has more information than the other? How might this affect financial markets? Which side of a financial market is more likely to have better information than the other. How might this have affected the financial markets in the 2007-08 crash? What can be done to solve this problem? Could any of these solutions avoided the 2007-08 crash?

Answer 1

In a market when one side has more information than the other then a situation of asymmetric information is created and this leads to exchange of goods or services at a price which is not the equilibrium price. In case of financial markets if the buyer has more information with regards to a financial security then he knows that the security is underpriced relative to its aggregate performance. On the other hand if the seller has more information then the seller knows that the security is overpriced. Usually the seller is more likely to have better information than the buyer.

This might have affected the financial markets in the 2007-08 crash. In the crash of 2007-08 asymmetries with regards to information was the primary problem for mortgage backed securities. In cases involving mortgage backed securities lenders screen potential borrowers and originate mortgages. The mortgages are then packaged and sold to outside investors. The problem is that the investors cannot verify whether the screening has been done carefully or not. To avoid the problem the agents should insure that the principals have sufficient information to assess potential risk and reward. Agents and specialist third parties like hedge fund managers should be made accountable and responsible for sharing more and better information with the investors and buyers. This could have avoided the 2007-08 crash as the buyers would have been better aware of the high risk element that is present in the mortgage backed securities and other such complex derivative instruments that were being used at that time.