Question

Explain how the use of collateral in financial markets can lessen the effects of asymmetric information in the form of adverse selection.

Answer 1

There are immense risks involve when there is a problem of asymmetric information. Either of the two parties involved in the transaction has more information than one party.

Adverse Selection occurs when the transaction has not taken place. It happens because of wrong judgment or choice made on part of one party against the other party.

So, there are high chances that one party may default in future if proper inspection and supervision is not done. So, the person who lends or make contracts in the financial market is worried about the other party's future actions and the money that has been put in place.

Collateral in such case provides financial securities to such contractors and lenders. The whole idea of using collateral was brought up due to high default risks in the Financial Market. It reduces the problem of adverse selection by requiring specific value of the collateral. The contractor is insured that some percentage of invested money would be recovered from the collateral if other part defaults.

So, collateral works to hedge against the risk and protect the parties to safeguard themselves from asymmetry information problems like Moral Hazard and Adverse Selection.

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