4.

6 INFORMATION ASYMMETRY
4.6.1 A Closer Look at Information Asymmetry
1. Two major types of information asymmetry: adverse selection and moral hazard.
Adverse selection: Investor concern about adverse selection arises
when one type of participant in the market (insiders, for example) knows
something
about the asset being traded that another type of participant (ordinary
investors) does
not know.
Moral hazard: Investor concern about moral hazard arises because manager effort
in running the firm is typically unobservable, creating the possibility that
the manager may
shirk on effort.

An example for both adverse selection and moral hazard cases (From textbook)
Assuming you are risk averse, you may wish to buy insurance against the
possibility of failing to attain your university or college degree or
professional accounting designation.
You can get reimbursement if you fail to graduate in the degree or accounting
designation due to serious illness or accident. Sounds good? But this is
impossible to exist in the real life.
Both of the adverse selection problem and the moral hazard problem are
including in this insurance policy.
Adverse selection part: People who are sick would flock to enroll in
educational
programs (The insurance company is hard to tell high-risk customers from low
risk customers. This insurance policy will attract those high-risk customers to
buy which cause the company bust at the end).
Moral hazard part: People who owned such a policy, they would probably shirk
their studies, even if they were perfectly healthy (They don’t want to study
hard if they have such insurance policy).

This example proves that information asymmetry will cause the market
incompleteness. The insurance company will not offer such policy because of the
information asymmetry. They are not sure what cause your fail. (illness,
accident or shirking)

Another example for information asymmetry (From textbook)

In the used car market, the owner of the car will bring a “lemon” to market
and the buyer will lower the price they are willing to pay for any used car to
protect themselves from buying a “lemon”.
What causes this phenomenon? Information asymmetry. The owner of the car will
know more about its true condition, and hence its future stream of benefits,
than would a buyer.
What is the result of this phenomenon? The good cars will have a market value
that is less than the real value of future stream of benefits, and vice versa
for bad cars. The sellers of the good cars are less likely to bring them to the
market.

This example also proves that information asymmetry will cause the market
incompleteness.
If the sellers of the good cars continue to quit the market, the market will
collapse in the end.

2. How to solve information asymmetry?

As we known, the information asymmetry is caused by the unbalanced information
between the buyers and sellers. If we can make them balance, the problem is
solved.
In the example of used car market, safety certificates, repair records,
warranties, test drives, dealers who want to establish a good reputation all
can reduce the effect of information asymmetry.
In the example of insurance policy, medical examinations for life and health
insurance, co-insurance and deductible clauses for fire insurance, and premium
reductions for good driving records all can reduce the effect of information
asymmetry also.
In both of the examples, the devices that solve the problems though reducing
the estimation risk. In other words, the buyers get more useful information to
decide. But getting more information means more cost, it is a trade-off
question.

3. Let’s think about the similar situation in the stock market.

What causes the information asymmetry in the stock market? Inside investors
know more information about the firm’s real future performance prospects than
the outside investors.
Then, the inside investor may exploit the information advantage to get more
profits for themselves.
What is the result of information asymmetry in the stock market? The market
price will reflect outside investors’ expected losses at the hands of
insiders. The outside investors making buy or sell decisions face an
expectation of loss whether the inside information is good or bad.
How to solve the information asymmetry in the stock market? As mentioned above,
if the outside investors get as much information as the inside investors, they
can eliminate the estimation risk which caused by the information asymmetry.
For example, by superior disclosure of the firm’s inside information.
There are two ways to protect the outside investors from information asymmetry
considered by Jagolinzer, Larcker, and Taylor (JTL;2011). They are blackout
policies and general counsel approval.
Blackout policies restricts firm insiders from buying or selling company
shares during periods when they are particularly likely to possess inside
information.
General legal counsel is required to approve insider trades for firm.
From the reports, JTL conclude that general counsel approval is a more
effective corporate governance device than blackout period. (Shows in textbook
Pg140.)

4.6.2 Fundamental Value

1. What is fundamental value of a share? The fundamental value of a share is
the value it would have in an efficient market if there is no inside
information. That is, all existing information about the share is publicly
available.
2. Figure 4.2 Role of Financial Reporting in an Efficient Market

The outer circle of the figure depicts the firm’s fundamental value. The inner
circle
depicts the information underlying the efficient market price of the share,
being all
publicly available information. The difference between the inner and outer
circle
depicts inside information. The role of financial reporting is to convert
inside information
into outside information, thereby enlarging the inner circle. As mentioned, the
inner
circle cannot fully reach the outside, since the cost of eliminating all inside
information
would be astronomic. (From textbook page 141)

This paragraph is clear enough to explain the role of financial reporting in an

efficient market. In simple words, if the inner circle matches the outside
circle, the market will be in the perfect situation. This is obviously
impossible in the real world because of the cost problem. What the outside
investor can do is to make the inner circle large enough relative to the
outside circle.
3. Some research for the useful of financial reporting.
Enron, WorldCom and financial institutions found that if investors realized
that much of the information in the inner circle is not useful, the market will
collapse due to the inner circle collapses.
Research by Maffett (2012) supports the argument that higher quality financial
reporting
can benefit investors.
First research based on a sample of 42,930 mutual funds (his proxy for
sophisticated investors) from 42 countries over the period 1999–2009, and
43,290 firms in these countries,
The sophisticated investors could get information advantage though financial
reports based on the expense of ordinary investors. With a higher quality
financial reports, the ordinary investors would get more information and
prevent themselves from the situation above.
The second research is about the estimated country-level financial reporting
quality for the countries. As he pointed out, this suggests that improvements
in a country’s accounting standards and corporate governance can reduce the
information disadvantage of ordinary investors.

4.7 The social significance of securities markets that work well

1. What the socially desirable? The socially desirable that the securities
markets work well—that is when share prices close to the fundamental value.
2. Why? Firms could invest in capital project and create an efficient capital
allocation. They can earn the largest profits from it.
3. Is it possible? As mentioned before, the share price does not fully reflect
fundamental value in the presence of inside information in the real life. Lemon
phenomenon mentioned before will cause investors withdraw from the market. What
is the result of that? The market loses depth and further hampers investments.
4. What helps securities market work well? Countries with more firm-specific
information incorporated into share prices (relative to industry- and economy-
wide information, which affects all share prices) enjoy greater capital
allocation efficiency.
This conclusion is provided by Wurgler (2000) who estimated the efficiency of
capital allocation for 65 countries over the years 1963-1995.
5.How does firm-specific information become incorporated into share prices? An
answer is through high quality reporting.
The effect of reporting quality on capital allocation was studied by Francis,
Huang, Khurana, and Pereira (FHKP; 2009). They predicted if two countries have
similar high-quality reporting, the growth rates by industry in each country
should be similar (i.e., highly correlated) if reporting quality is a
significant determinant of capital availability.
After a research on a sample of industry growth rates from 37 countries over
the period
1980–1990, they proved their prediction.
6. How to improve the reporting quality? There are two ways discussed in the
textbook. They are regulation and market incentives.
Regulation: Setting accounting standards, control, insider trading, and promote
timely disclosure of significant events, with penalties for violation.
Market incentives: Releasing inside information over and above that required by
regulation to enjoy higher share prices and lower cost of capital.
Both of them help to eliminate the inside information of the firm. It is easily
to understand why they improve the report quality.