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Asymmetric information and corporate

financial structure

Chap 8, Mishkin

Combine with class handouts

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Corporate financial structures across developed nations reveal some common features:

1. The methods of financing in order of importance are

implying is more important than and form the most important type of

2. Only a few large corporations have

3. are a common feature in . These contracts also place substantial

4. Financial systems are heavily

This chapter and the accompanying handout “Market for lemons” try to show how these features are a product of asymmetric information problems and transactions costs in corporate financing.

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Financial intermediaries have evolved to

1. reduce

2. reduce

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Asymmetric information problems are of

• Adverse selection

• Moral hazard

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Equilibrium price and trade under adverse selection

A dealer sells two types of used cars – (i) good quality or “peaches/plums” (sweet) and (ii) bad quality or “lemons” (sour). Buyer doesn’t know which car is which.

Buyer value for “peaches” = $3000

Buyer value for “lemons” = $1500

Cost of “peaches” to seller = $2500

Cost of “lemons” to seller = $1000

Number of buyers = 40

Number of “peaches” = 15

Number of “lemons” = 15

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Equilibrium under full information

buyer can observe the quality of the car.

Market for peaches Market for lemons

p p

QQ

Equilibrium in market for peaches = ( _____, ____ )Equilibrium in market for lemons = ( _____ , ____ )Total gains from trade = _________________________________

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Equilibrium under hidden information

Buyer doesn’t know the quality of the car and has “pessimistic” beliefs.

price

quantity

Equilibrium in the market for used cars = ( ____, ___)Only ____ quality cars are traded. ____ quality cars are driven out of the market because _____________.

Total gains from trade =

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Equilibrium under hidden information (contd.)

What other belief structures are possible for buyers to have? ____________

price

quantity

Is it possible to have an equilibrium with thealternative belief structure?Hint: In equilibrium thebelief structure must be sustainable.

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“Lemons” (adverse selection) problem in stock and bonds markets

When a lender cannot distinguish between “good” stocks (bonds) and “bad” stocks (bonds), she/he

As a result

Ways to reduce

1. private production and sale of information by specialized firms

example: S & P, Moody’s,

this arrangement creates its own problem:

2. Govt. regulation to increase information

example:

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3. financial intermediation

4. collateral and “net worth”

net worth of a firm = performs a similar function as a collateral;

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Moral hazard problem in stock and bonds markets

When a lender cannot control the actions of a borrower

Ways to reduce moral hazard problems:1. Monitoring

2. Financial intermediation

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3. Designing an appropriate contract

Debt vs. equity

Collaterals

Restrictive covenants

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“Conflicts of interest” - a special type of problem in financial markets

Financial intermediaries essentially

Conflict of interest =

Example 1: investment banks research and underwrite firms

Example 2: auditing and consulting in accounting firms

Sarbanes-Oaxley