Information Asymmetry

Information asymmetry is common in finance. Company managers know more about their business than outside investors. Borrowers know more about their ability to repay than lenders. Sellers of used goods know more about their condition than buyers.

It can lead to two main problems. Adverse selection occurs before a transaction, when the less-informed party risks attracting the wrong type of counterparty, such as an insurer attracting mostly high-risk customers. Moral hazard occurs after a transaction, when one party changes its behaviour in ways the other cannot observe.

For example, when a company announces it will issue new shares, investors may suspect managers believe the shares are overvalued, since managers know more about the company's prospects. As a result, the share price often falls.

Many financial practices exist partly to reduce information asymmetry, including audited financial statements, credit ratings, disclosure rules, due diligence, warranties and signalling actions such as paying dividends. It is central to theories such as the pecking order theory and signalling theory.