Adverse selection in Securities Market

Adverse selection in Securities Market

1. Managers have more information thann the potential investors about their firms

   • Investor are unable to distinguish between good bonds and stocks
     • investor are only willing to pay a price refelecting the average quality of the market
       • owners and managers of good quality (low risk / high return) firms are not willing to sell at that price as they know that thier stocks / bonds are undervalued
         • Only sellers available in the market are of bad quality (High risk & low return) that are happy to sell thier stock and bonds as they are over valued
           • Investor is unable to select a good firm / investment
             • investor buys no stock
   • assymetry of information

2. reduce / solve problems arising from adver selection

   • Private production and sale of information
     • private companies produce and sell information needed by investors to distinguish good and bad firms & to select their securities.
       • Information concerns the financial statements of firms and their investment activities.
       • examples of such firms Standard and Poor’s, Moody’s and Value Line
         • Debt Ratings, 7 Major classes refelcting credit quality
           • AAA, AA, A, BBB
             • investment grade
           • BB, B, CCC, CC, C, CI, D, NR
             • JUNK BONDS
       • Adverse selection is not completely solved by the private production
         • FREE RIDER PROBLEM
           • Other investors who do not pay for information mimic your investment decisions
             • many investors flock to buy the same undervalued security
               • increase of security price to its true vakue
                 • negates the value of information
                   • investors reluctant to buy information
             • adverse selection remains
   • Government Regulations
     • governments take steps to ensure that firms disclose full information to potential investors.
       • financial markets are among the most heavily regulated sectors in the economy
       • government agency are entrusted to promote the adherence to standard accounting principles and disclosure of information.
         • disclosure requirements do not solve the adverse selection problem
           • Managers have tremendous incentives to hide their companies’ problems, making it hard for investors to know the true value of the firm
             • Enron collapse Dec 2001 was valued $77 billion year before
               • Enron was engaged in a complex set of transactions by which it was keeping substantial amounts of debt and financial contracts off of its balance sheet. These transactions enabled Enron to hide its financial difficulties
   • Financial Intermediaries
     • financial intermediaries, and especially banks, produce more accurate valuations of firms and are able to select good credit risks thanks to their expertise in information production
       • One particular advantage that banks may have is information about borrowers from the transactions on their bank accounts: banks obtain a profile of the suitability for credit (and ability to repay the loan) from the accounts of their customers
         • banks are able to avoid the free-rider problem because their loans are private securities, not traded in the open financial market. investors are not able to observe the bank and bid up the price of the loan to the point where the bank makes no profit on the production of information
     • banks reduce the adverse selection problem by asking the borrower to provide collateral against the loan. Collateral is property promised to the lender if the borrower defaults. Therefore it reduces the losses of the lender in the event of a default.
     • Informational Economy of Scale
       • Pyle & Leland