Chapter 3 Transaction Costs Asymmetric Information and the Structure of the Financial System Collateralized Debt Obligations CDO s are typically composed of mortgage backed securities and other nancial assets Obstacles to Matching Savers and Borrowers The Problems Facing Small Investors Transaction costs are costs of making a direct nancial transaction such as buying stock or bond or making a loan transaction costs would include the legal fees you would have to pay to draw up a contract with the borrower of your money and the time you spent trying to identify a pro table investment Information cost are the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the acquired funds Savers receive a lower return on their investments and borrowers must pay more for the funds they borrow in some cases these costs mean that funds are never lent or borrowed at all Transactions costs and information costs reduce the e ciency of the nancial system they also create a pro t opportunity for individuals and rms that can reduce those costs How Financial Intermediaries Reduce Transaction Costs Economies of Scale is the reduction in average cost that results from an increase in the volume of a good or service produced The Problems of Adverse Selection and Moral Hazard Asymmetric information describes the situation in which one party to an economic transaction has better information than does the other party In nancial transactions the borrower has more information than does the lender Two problems arising from asymmetric information Adverse selection is the problem investors experience in distinguishing low risk borrowers from high risk borrowers before making an investment Moral hazard is the problem investors experience in verifying that borrowers are using their funds as intended Adverse Selection George Akerlof UC Berkeley was the rst to analyze the problem of adverse selection using a used car reference The seller of a used car will always have more information on the true condition of a car than will a potential buyer A lemon or a car that has been poorly maintained could have damage that an auto mechanic might have di culty detecting Expected return is calculated by adding up the probability of each event occurring multiplied by the value of each event Expected value is the probability car is good X value if good probability car is lemon X value if a lemon OR 0 75 X 15 000 0 25 X 7 000 13 000 Expected Value Used car market is subject to adverse selection The problem of adverse selection reduces the total quantity of used cars bought and sold in the market because few good cars are o ered for sale Lemons Problems in Financial Markets Attempts to Reduce Adverse Selection The fundamental value of a share of stock should be equal to the present value of all the dividends an investor expects to receive into the inde nite future Suppose that given your expectations of future dividends to be paid you believe that the value of the stock issued by a good rm is 50 per share but the value of stock issued by a lemon rm is only 5 a share 90 of rms o ering stock for sale are good rms and 10 are lemon rms Expected value 0 90 X 50 0 10 X 5 45 50 so you would be willing to pay 45 50 for a share of stock but to a good rm this is below the fundamental value of the stock Good rms will be reluctant to sell stock at this price but lemon rms would be very willing to sell stock at this price because it is well above true value of their shares Consequence of adverse selection is that many small to medium rms are unable to issue stock because it will be hard to nd investors willing to buy their share because investors will be afraid of buying stock in what may turn out to be a lemon rm or unwilling to sell shares for far below their fundamental value In the US only 5100 rms are publicly traded which means that they are able to sell stock on the stock markets Credit rationing is the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate In 1934 Congress established the Securities and Exchange Commission SEC to regulate the stock and bonds market they require that publicly traded rms report their performance in nancial statements such as balance sheets and income statements that the rms must prepare using standard accounting methods Material Information is information that if known would likely a ect the price of a rm s stock The disclosure of information required by the SEC reduces the information costs of adverse selection but it doesn t eliminate them for several reasons First some good rms may be too young to have much information for potential investors to evaluate Second lemon rms will try to present the information in the best possible light so that investors will overvalue their securities Third there can be legitimate di erences of opinion about how to report some items on the income statement and balance sheets For example during the nancial crisis many banks and nancial rms had assets such as mortgages and loans on their balance sheets and income statements that had become illiquid Markets for these assets seized up meaning little or no buying and selling was occurring in them Investors had hard times nding the true prices of the assets by reading the rms balance sheets Forth the interpretation of whether information is material can be tricky For example Apple was criticized by some investors when they announced that Steve Jobs was having a liver transplant Reps of Apple believed that his health was a private matter while investors believed these problems should have been more fully disclosed because they could have a ected the future pro tability of the rm and therefore its stock prices Private rms buy information on a company and sell it to investors to reduce the costs of adverse selection Buyers include individual investors libraries and nancial intermediaries Private information gathering rms can help minimize the cost of adverse selection but they cannot eliminate it Free riders are individuals who gain the information without paying for it The Use of Collateral and Net Worth to Reduce Adverse Selection Problems The disclosure of information either directly government regulation or indirectly private information gathering rms does not eliminate adverse selection so lenders often rely on nancial contracts that are designed to help reduce the problem To make it more costly for rms to take
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