How does government regulation reduce adverse selection in stock and bond markets?

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Expert Solution

A situation where the sellers have information that the buyers do not possess regarding anything related to the product quality can be called as adverse selection. It is basically an information failure where one entity has greater product knowledge than the other one. It can also be termed as assymetric information.

In case of stock and bond markets, where companies participate in terms of their market value and number of shares, there is a possibility that interests of retail investors are controlled by operator plays. The operators based on the inside information they get from the companies, may increase the stock price of a firm by buying huge volumes which in turn boost the share prices. After their set target, they exit their positions resulting in a bearish condition. This happens usually even with the regulations of the stock markets in place and hence there is a need to strengthen the stock market regulatory authority. The improvements in regulation can be done by adopting technological advancements and simulation process in the stock markets.

In case of FIIs and FDIs, the conditions of the market needs to be transparent and market frauds needs to be eliminated for them to actively participate in the exchange. More and more FDIs and FPIs inflow happens only when there is trustable regulation in the market. Deregulated crypto currency frauds happen most often because of no regulations in the system. Regulations can build confidence in market participation by investors and traders and can reduce bad investing by promoting value investing. A value investing is done when investors have clear knowledge about the fundamentals of the firm. There occurs the need to be transparent with the financial statement of a company. A company listed in the stock markets need to publish relevant information about the operations and financials of them so that investors get a clear picture of them.

All these can be done only if there is ample regulations in the market whether in case of equities or derivatives.

Rahul Sunny answered 1 year ago

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