Question

Information asymmetry is regarding as a major challenge in financial intermediation process.

1) With the use of examples, example how both Adverse Selection and Moral Hazard problems may occur in financial markets.

2) Provided a mitigation strategy to address the information asymmetry problems presented in 1) above

Answer 1

1. Moral hazards and adverse selection arising out of information asymmetry and due to difference in information which is available to the sellers and buyers.

In moral hazard situation,when two parties are entering into the contract, one party will be providing the misleading informations and it will be trying to change their behaviour completely after the agreement has been made so they know that they would not be facing any of the consequences.

In adverse selection problem both the parties who are entering into the contracts are having a difference in the information which is available to the parties so the seller will be thinking that he is having higher information than the buyer and the buyer will think that the he is having a higher amount of information that the seller so they both should be making certain wrong acts which are not in due with the agreement.

2. This kind of moral hazards and adverse selection should be managed by better availability of information which are available to the parties which will be helping the parties in making the right decisions and the responsibility should also be fixed.