Asymmetric Information

1
Asymmetric Information

• Introduction
• Asymmetric information (AI) refers to the
• fact that borrowers have better information
• than lenders.
• AI exists whenever the lender lacks the
• necessary information and control on the
• borrowers ability and willingness to repay
• her debt.
• Because the borrower uses someone elses
• money she has the incentive to
• disguise the true nature of her project.
• use the funds in a project different to the one
  she applied for.
• announce lower than actual earnings in order to
  reduce her financial obligations at the lenders
  expense.

2
Asymmetric Information

• Introduction
• AI has important implications for a wide
• range of issues. These include corporate
• debt, investment, dividend policy and the
• development of the financial system.
• The formal study of AI begun in the early
• 1970s.
• By now AI is an essential part of any
• Financial Economists tool kit.
• The theoretical and practical importance of
• AI are well recognized. The 2001 Nobel
• Prize for Economics went to its pioneers,
• George Akerlof, Michael Spence and
• Joseph Stiglitz.

3
Asymmetric Information

• Economic Characteristics of Financial
• Contracts
• To understand AI we need to investigate the
• fundamental relationship between a lender
• and a borrower.
• A financial contract will be agreed upon only
• if the expected profit of the borrower and
• lender is equal to or higher than the next
• best alternative project. This is called the
• participation constraint or individual
• rationality constraint.
• No rational individual will take part in an
• investment either with negative expected
• return or with a profit that does not reach a
• minimum expected return. This minimum
• floor is called the required return.

4
Asymmetric Information

• Economic Characteristics of Financial
• Contracts
• An Example
• Suppose there is only 1 productive investment I
  R100.00 financed by a loan
• 1 year later it gives 2 possible cash flows if
  successful, CFs R300.00, if it fails, CFf R0.
  
• The probability of success is as 0.7 and the
  probability of failure is af ( 1- as) 0.3.
• The required return r 10.
• The expected value EV of the project is
• EV as CFs af CFf
• 0.7R300.00 0.3R0
• R210.00

5
Asymmetric Information

• Economic Characteristics of Financial
• Contracts
• The project involves risk because if it fails
• the entrepreneur is unable to pay and goes
• bankrupt. CFf will be transferred to the bank.
• The banks cost of deposits are on the LHS
• and its revenues from loans on the RHS.
• Assume revenue just covers cost
• competitive market with no abnormal profits.
• Solve for the interest rate on the loan rL.
• (1r)L as (1rL)L af CFf
• (1r)L as (1rL)L
• (1rL) (1r)/ as
• rL (10.1)/0.7 1 1.1/0.7 - 1

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Asymmetric Information

• Economic Characteristics of Financial
• Contracts
• The borrowers expected profit is
• Ep as CFs - (1rL)L
• 0.7R300 (1.57)R100
• R100.00
• The banks expected income is
• EI 0.7(1.57R100) R110.00
• Both parties will enter into the contract.

7
Asymmetric Information

• Economic Characteristics of Financial
• Contracts
• Now assume that
• The borrower knows the true probability of
  success to be 70 but reports 90 to the lender.
• The lender has no way to verify what the borrower
  says.
• As before, if the project fails, the loan is not
  paid.
• Based on this information rL (10.1)/0.9
• 1 1.1/0.9 1 22.
• The borrowers expected profits increase to
• 0.7R300 (1.22)R100R124.60.
• The banks expected income falls to
• 0.7(1.22R100.00) R85.40.

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Asymmetric Information

• 2 Main Types of Asymmetric Information
• Adverse Selection
• Moral Hazard

9
Asymmetric Information

• Adverse Selection
• Key contribution by George Akerlof (1970).
• A lender suffers from adverse selection
• when he is not able to distinguish between
• projects with different credit risks when
• allocating credit.
• Given 2 projects with equal expected value,
• the lender prefers the safest one and the
• borrower the riskiest one.
• Those undertaking risky projects will try to
• hide the true nature of the project.
• Adverse selection is a problem of hidden
• types. Occurs before signing of contract.

10
Asymmetric Information

• Adverse Selection
• Two types of borrowers
• A good quality borrowers charged rA.
• B poor quality borrowers charged rB.
• Riskier borrowers are penalized with a
• higher interest rate.
• Thus, type B borrowers have an incentive to
• pretend to be type A borrowers (want to pay
• rA).
• Bank does not know types. He only has
• information on proportion of type A and type
• B borrowers.

11
Asymmetric Information

• Moral Hazard
• By moral hazard we mean the borrowers
• ability to apply the funds to different uses
• than those agreed upon with the lender.
• Moral hazard is a problem of hidden action.
• It occurs after signing the contract.
• Assume 2 projects
• H High quality in eyes of the bank.
• L Low quality in eyes of the bank.
• But borrower has incentive to divert funds to
• L because although risk is higher, return is
• also higher.

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Asymmetric Information

• Moral Hazard
• The likelihood of moral hazard increases
• with the amount of debt.
• Why?
• More debt implies borrower has a smaller stake in
  the project. More likely to engage in risky
  behaviour.
• More debt implies greater payoffs if project is
  successful.
• Moral hazard is also present in insurance
• markets. Undertake more risky behaviour to
• get a large payout.

13
Asymmetric Information

• Implications for Corporate Financing
• Key characteristics of debt financing
• High dependence on retained earnings. 71 in
  developed countries and over 80 in developing
  countries.
• Dominance of debt over equity.
• Adverse selection means that buyers of
• shares will only be willing to pay the
• average price of good and bad stock
• Pg price of good stock, Pb price of bad
• stock
• P ß1Pg ß2Pb where Pblt P lt Pg
• Adverse selection discourages the issuance
• of shares for the best projects and
• encourages issuance of the worst ones.

14
Asymmetric Information

• Implications for Corporate Financing
• With adverse selection the issuance of
• shares can be viewed as a signal of poor
• project quality.
• That is, good quality shares will be
• discounted so they will not be issued. Only
• poor quality shares have an incentive to
• issue.
• Researchers have found that the market
• value of shares drops when they announce
• a stock issue, but this does not occur when
• debt is issued.

15
Asymmetric Information

• Implications for Corporate Financing
• The implication is the following pecking
• order of financing sources
• Internal funds
• Debt
• Stock Issues
• Debt is backed by a banks valuation of the
• Projects (despite AI).
• Stock issues are made with little or no
• external valuation of the projects.