Question

. It is often stated that "we live in an information age," yet the adverse selection problem still exists. Why?

4. Which government regulatory agency was created in great part, to help overcome the adverse selection problem in equity markets?

5. High deductible are used in which financial market to help address the moral hazard problem?

Answer 1

3. Adverse Selection:

This is a situation in which buyers and sellers having different information regarding a particular transaction. Due to difference in information, there will be some undesirable results in the economy. This situation is called as an "Adverse Situation". The information may be related to Quality of the Product or anything else. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance. To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.

An example where the buyer is adversely selected against is in financial markets. A company is more likely to offer stock when managers privately know that the current stock price exceeds the fundamental value of the firm. Uninformed investors rationally demand a premium to participate in the equity offer. While this example functions as a good hypothetical example of the buyer being adversely selected against, in reality the market can know that the managers are selling stocks (perhaps in required company reports). The market price of stocks will then reflect the information that managers are selling stocks.

Hence it may be said that It is often stated that "we live in an information age," yet the adverse selection problem still exists.

4. SEC (Securities and Exchange Commision) is the name of the government regulator which is responsible for estabilishing controls over adveerse selection.

5. Moral hazard, essentially, is risk taking. Generally, moral hazard occurs when one party or individual takes risks knowing that, if the risk doesn't work out, another party or individual then suffers the burden of the consequences related to such behavior. In some instances, moral hazard may occur where the actions taken are a disservice to another once a transaction has taken place.

For example, mortgage securitization can lead to moral hazard. Originators of mortgages have the ability to pool the mortgages and then portion pieces to investors, thus passing the risk of default on to someone else instead of holding onto it. When an agency purchases the mortgage pool, the risk is passed to it. In such a situation, it benefits the agency to cut down moral hazard by being diligent in monitoring the originators of the loans and by verifying loan quality.

High deductible are used in Health Insurance Plans to ensure that the insurance holder must pay for medical expenses before insurance coverage kicks in