Asymmetric Information in Financial Markets: Introduction and Applications

This book highlights the fundamental role that asymmetric information plays in the functioning of financial markets. The necessary theoretical concepts from the literature on the economics of information and incentives are introduced to the reader in the context of borrower‐lender relationships, and with a minimum of jargon and mathematical complexity. The book should therefore be of particular interest to practitioners and undergraduate students as an introductory text to the economics of banking and financial markets. It may also be of interest as a supplementary text to more advanced students using Freixas and Rochet’s classical text on the topic (Freixas and Rochet, ‘The Microeconomics of Banking’, MIT Press 1997). In the present book, the author takes the existence of financial intermediaries in a fully competitive environment as given. Chapter 1 introduces, by means of three simple examples, the main types of informational asymmetries that may affect the borrower‐lender‐relationship: ... The first four chapters of the book are slightly more formal than the rest, explicitly taking up the examples from Chapter 1 to explain real‐world features of debt contracts and other issues arising in Corporate Finance. In Chapter 2, this adverse selection example is used to explain the phenomenon of credit‐rationing, whereby the lender, instead of raising interest rates, limits the amount of credit he is willing to provide. The adverse selection example also serves as the basis for explaining other observed features of real‐life debt‐contracts: the use of collateral and the borrower’s use of internal funds to part‐finance a project.