Finance and Accounting - Asymmetric Information and Its Phenomena - Literature review Example

Finance and Accounting Asymmetric Information and its phenomena Asymmetric Information entails a situation where one particular party that is in a transaction has superior information unlike the other. In most cases, asymmetric information occurs during transactions whereby the seller has more information than the buyer does. However, the reverse applies in certain situations (Ong, 24). One of the biggest disadvantages of this is that, one party can easily take opportunity of the other party. In simple terms, asymmetric information or information asymmetry entails the study of transaction decisions where a particular party seems to have better information on a particular aspect than the other party. Generally, asymmetric information aspect tends to create power imbalance especially in transactions and can sometimes lead to a market failure such as moral hazard, adverse selection and information monopoly. It is the case of one party being enlightened than the other party. Alternatively, one party can has the ability of enforcing or efficiently retaliating for breaches of various agreement parties where the other party fails (Ong, 34). Asymmetry Information tends to cause misinformation, which is seen as important in all the communication process. However, asymmetry information contrasts to perfect information that remains an important assumption especially to neo-classical economics (Ong, 45). One of the main problems that mostly arise from information asymmetric is the aspect of adverse selection. In this case, adverse selection happens when an adverse outcome in a particular market exchange tends to result because the sellers or the buyers make decisions that are based on imperfect information. In most cases, this result in the type of market that generally exchanges goods that is of lesser quality. This type of market is also known as the lemon markets (Ong, 64). Asymmetric information remains a common phenomenon in most financial markets (Ong, 84). The workhorse model that entails studying asymmetric information especially when it comes to competitive financial markets tends to have rational expectations. In most cases, asymmetric information tends to show up in every market exchanges. However, hardly do both market sides have equal market information regarding the good exchanged. This is because they tend to have a control of the goods, which the sellers have effective information as compared to the buyers. This makes the asymmetric information an essential aspect when it comes to the financial markets (Ong, 73). In most cases, stock prices tend to be based in most parts of the buyers and sellers information that they have regarding the profitability and productivity of the organization. This means that, people with better information always tend to succeed thus buying low and selling at high prices. On the other hand, the financial insurance markets mostly rely heavily on information, which is accurate. For example, people who are insured tend to have information, which are better regarding their own health as compared to the health insurance providers. Another example where the asymmetric information applies is the employment of labor. In most cases, the employees tend to have extensive information regarding their own talents, skills and productivity as compared to their employers (Ong, 102). The financial markets insurance and the labor employment are some of the best examples where the asymmetric information best applies. Credit ratings Credit ratings generally entail an assessment of the credit worthiness especially of a debtor and this can be the government or a business franchise, but not the customers. In most cases, the evaluation is usually made through credit rating agencies whereby the debtor’s has the capability to pay back any default likelihood or debt (Ong, 74). Generally, credit ratings are usually determined by the credit ratings agencies whereby the credit rating would represent the agency evaluation of both quantitative and qualitative information for the government or the company; including the non-public information that might be obtained by analysts from credit rating agencies. Alternatively, evaluations of individuals’ credit value are regarded as credit reporting. In most cases, they are done by consumer credit reporting agencies or bureaus which tend to issue credit scores (Ong, 52). Aim of credit ratings The main aim of credit ratings is to assist in reducing information asymmetry. In most cases, credit ratings aid its users towards the reduction of information and knowledge gap that exists between investors and borrowers. Alternatively, credit rating is put in a way that it will help in cutting down the extensive knowledge or information that one party has in a market situation. By doing this, the significant subject of the information asymmetry always remains on the borrower’s creditworthiness (Ong, 58). The other aim of credit ratings is to help in improving market efficiency and function. In most cases, this description tends to focus on ways in which credit ratings tend to contribute to market operations instead of the role they play on specific market participants especially in transactions. This means that credit ratings help in reducing investor’s ability to outperform another (Ong, 84). This is usually done through establishing better judgments regarding credit worthiness. Alternatively, credit ratings are designed in such a way that they have the ability to always convey forward-looking summary opinions regarding security creditworthiness. Additionally, credit rating aspect is the fact that credit rating plays a big role in managing finances and budget effectively (Ong, 94). Most of the functions of credit ratings always tend to alleviate asymmetric information in the financial markets especially with the way they are designed. However, credit ratings also play a huge role in misinterpretation of information in the financial markets. Credit ratings tend to mislead its users something with is seen as unnecessary in the financial markets. However, with the help of the asymmetry information contrasts to perfect information that remains an important assumption especially to neo-classical economics. Advantages and disadvantages of credit rating for financial markets Advantages of credit ratings One of the biggest advantages of credit ratings is that they help in the reduction of information asymmetry. In this case, credit ratings help in reducing the knowledge of information gap between lenders or rather the investors and borrowers. Generally, the essential subject matter of this particular information asymmetry remains the borrower’s creditworthiness. Alternatively, credit ratings help in improving market efficiency and function. In most cases, this description focuses on ways in which credit ratings tend to contribute to market operations instead of the role they play on specific market participants especially in transactions. This means that credit ratings help in reducing investor’s ability to outperform another. This is usually done through establishing better judgments regarding credit worthiness. The mechanism through which the aspect of credit ratings helps in improving marketing effectively is through the reduction of information asymmetries. Additionally, credit ratings play a big role in financial markets by acting as an unbiased and an independent second option which an investor can make use of in refuting or confirming his own analysis. In most cases, credit ratings are symbols of conveying information. In doing this, the credit ratings always convey forward-looking summary opinions regarding security creditworthiness. Another major advantage of credit rating aspect is the fact that credit rating plays a big role in managing finances and budget effectively. In most cases, an organization tends to benefit from low interest rates and rewards. Disadvantages of credit ratings to financial markets The biggest disadvantage of credit ratings is the misuse of credit rating and failure to fulfill their given role. In most cases, the credit rating may hurt the user especially during financial problems. Generally, credit ratings always go down in case the user loses his job or experiences medical emergencies. Alternatively, credit ratings tend to lock a person into subprime category whereby he may pay excessive high interests for loans. The user might also experience trouble while making on-time payments due to expensive loans. The other disadvantage of credit rating is the rating shopping aspect. The rating shopping aspect in most cases rarely involves sovereign, corporate and municipal bounds. However, it is usually common in securitization issues. Therefore, the rating shopping mostly hinders the ratings in fulfilling their role thus the reduction of information asymmetry. Alternatively, regulatory ratings use is another big challenge that is associated with credit ratings thus, their ability to perform some of their exact roles. Credit ratings may also experience difficulties when it comes to fulfilling their exact roles especially when investors tend to use then as supernumerary instead of using them as complement. In most cases, investors who use the credit ratings aspect as substitute when doing their own analysis, chances are that they may expect the ratings to deliver extremely higher than their normal deliveries. The role of credit rating has been condemned harshly during the concluded financial crisis. In this case, the credit rating aspect was being criticized for its default nature based on the analysis of the agency and the long-term economic prospects. Additionally, the credit rating was seen to hinder various aspects in the nation. One of the major derailleurs associated with credit ratings was its ability in fulfilling their role thus the reduction of information asymmetry. Work Cited Ong, Michael K. Credit Ratings: Methodologies, Rationale and Default Risk. London: Risk Books, 2003. Print. Read More