Question

Give a concrete example of adverse selection and moral hazard each in financial markets.

Answer 1

Adverse selection occurs before the financial transaction takes place, when potential bad credit risks are those ones who are most actively seeking out a loan. For instance, those who want to opt on big risks are likely to be the most eager to take out a loan, even at a high rate of interest, since they are less concerned with paying the loan back. Therefore, the lender must be actively concerned that the parties who are the most likely to produce an adverse or undesirable outcome are most likely to be selected as borrowers. Lenders required to try to tackle the problem of asymmetric information by screening out good from bad credit risks.

Moral hazard occurs after the transaction takes place. The reason is that a borrower has incentives to invest in projects with high risk in which the borrower does well if the project succeeds, however the lender bears majority of the loss if the project fails. There is a possibility that a borrower misallocate funds for personal use, to shirk and not work to his potential, and to undertake investment in unprofitable projects that serve only to increase personal stature or power. Therefore, a lender is subjected to the hazard that the borrower has incentives to engage in activities which are undesirable from the lender’s point of view: that involves activities that make it less likely that the loan will be paid back