1 Asymmetric information and corporate financial structure Chap 8, Mishkin Combine with class handouts

2 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.

3 Financial intermediaries have evolved to 1.reduce 2.reduce

4 Asymmetric information problems are of Adverse selection Moral hazard

5 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

6 Equilibrium under full information buyer can observe the quality of the car. Market for peaches Market for lemons pp Q Q Equilibrium in market for peaches = ( _____, ____ ) Equilibrium in market for lemons = ( _____, ____ ) Total gains from trade = _________________________________

7 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 =

8 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 the alternative belief structure? Hint: In equilibrium the belief structure must be sustainable.

9 “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:

10 3.financial intermediation 4.collateral and “net worth” net worth of a firm = performs a similar function as a collateral;

11 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

12 3. Designing an appropriate contract Debt vs. equity Collaterals Restrictive covenants

13 “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