Question

1. Define

a. Asymmetric Information

b. Adverse Selection

c. Moral Hazard

d. Name the three main bond rating agencies

Answer 1

1. Asymmetric information:

Asymmetric information is defined as failure of information that occurs when one party in the transaction possess greater material knowledge than the other party. The reverse is also possible. Almost all economic transactions can involve information asymmetry.

With respect to financial security, information asymmetry can occur when the buyer or seller has more information on past, present or future performance of the security. If the buyer has more information, then he is aware that the security is underpriced. On the other hand, if the seller has more information, then he is aware that the security is overpriced. Asymmetric information can provide the buyer or seller a better opportunity to make profit on the purchase or sale of security.

2. Adverse selection:

Adverse selection from financial perspective refers to a situation where sellers have information that the buyers don’t have or vice versa about the quality of the product. The asymmetric information can lead to poor decisions such as doing business with less profitable or more risky segments.

For example, a company may be willing to issue more shares when the price is more valued. In this case, buyers end up in buying over valued shares thereby losing their money

3. Moral hazard:

Moral hazard can be defined as a situation where one party involve in a risky event knowing that he is protected against the risk and the other party will incur the cost. In a financial market there is risk that the borrower may engage in activities that are not desirable from lender’s view point which reduces his chances of paying back the loan.

Moral hazard occurs when one party is aware of the fact that someone will be responsible for the mistake he makes. This will provide him the incentive to take risks.

4. Three top bond rating agencies:

Three top bond rating agencies in US are standard and poor, moody’s investor’s service and Fitch rating agencies. Each of them use a unique letter to inform the investors whether bond carries low or high level risk

And whether the issuer is financially stable. Standard and poor’s highest rating is AAA- and lowest is D which indicates bond is in default. Moody’s ratings are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. Fitch’s bond ratings are AAA, AA, A, BBB, BB, B, CCC, CC, C & D the latter defines that the bond is in default.