L2&L3: Introduction to Conceptual Frameworks - Information Asymmetry

Question 1

What does Rock, K. (1986) suggest about why new issues (IPO) are underpriced?

Answer 1

• Some buyers (investors) are more informed about the value of a transaction (IPO).
• The less informed buyers worry that they will overpay in the transaction (winner’s curse).
• The concern over the winner’s curse makes less informed buyers less willing to offer a high price.
• Severe winner’s curse problems can lead to a firm to pass on NPV positive projects.

Question 2

What is information asymmetry?

Answer 2

A situation in which one party to a transaction has more payoff relevant information than the other. The less informed part faces an adverse selection problem, in which the more informed party rigs the trade against the less informed.

Question 3

What is the lemon problem?

Answer 3

Firms (sellers) know more about their riskiness (type) than the bank does. Firms may claim to be less risky (higher quality) than they actually are. The bank (buyer) worries that the debt contract (terms of trade) will be disadvantageous because of the information asymmetry.

Question 4

What is a market failure?

Answer 4

A market failure (induced by adverse selection) describes a scenario in which certain types of sellers are missing from the market when they are present in the perfect information benchmark.

Question 5

What are key ingredients/conditions for market failure?

Answer 5

• Sellers have private information about their types.
• The price dictated by the average quality of all sellers is too low for high quality sellers.

Question 6

What are two ways to mitigate frictions that lead to market failure?

Answer 6

• Signaling (e.g. certification, capital structure)
• Screening

Question 7

What is signaling?

Answer 7

Actions by the more informed to credibly reveal their private information to the less informed.

Key idea:
- Find an action that is more costly for the imitator than the imitated.
- If the cost of taking the action exceeds the benefit from imitation, the imitator will stop imitating.
- The informed chooses to signal if it leads to a better private outcome than in the pooling equilibrium.

Question 8

What does Sufi, A. (2009) suggest about the effects of debt certification?

Answer 8

• Empirical strategy relies on the introduction of syndicated bank loan ratings by Moody’s and Standard & Poor’s in 1995.
• Availability of rating increased the use of debt by firms that obtain a rating.

The firms that obtain a rating:
- receive more lending from less-informed investors
- increase investment activities

Results are especially strong among those firms that did not have any credit rating prior to 1995 (no public debt).

Question 9

What is screening?

Answer 9

Actions by the less informed that allows it to infer the private information of the more informed.

Key idea:
- The less informed offer a menu of choices.
- Each choice corresponds to the more informed party’s private information.
- Deduce the informed party’s private information by observing their choice.

Question 10

What is a separating equilibrium?

Answer 10

A separating equilibrium prevails when both types of sellers are in the market and the buyer can distinguish between them because the sellers offer different terms.

In general:
- Low quality sellers receive the same terms that they would have received in the perfect information benchmark.
- High quality sellers bear the cost of signaling.
- High quality sellers receive worse terms than they would have received in the perfect information benchmark (if signaling is costly).

Question 11

What does Stiglitz, J. E., & Weiss, A. (1981) suggest about information asymmetry and lending?

Answer 11

• Contracts with higher interest rates discourage safer borrowers from taking out loans.
• The bank’s profits are non-monotonic in the interest rate charges (due to adverse selection).
• Collateral helps support a separating equilibrium because posting collateral is more costly for riskier firms.

Higher interest rates → worse borrower pool.

Question 12

What is the symmetric information benchmark?

Answer 12

No party (investor, entrepreneur) is privately informed about the situation. All believe in success with equal likelihood.

Question 13

What is the winner’s curse in the context of IPOs?

Answer 13

The uninformed investors receive a larger allocation of “bad” IPOs and a smaller allocation of “good” IPOs (when informed investors opt out of bad investments).

Question 14

What does the winner’s curse imply for financing?

Answer 14

Bad firm: informed will not participate. Uninformed will not participate after making calculations (in expectation negative to participate). → the IPO fails, which is good since the project was never NPV-positive in the first place.

Good firm: Informed will participate, but not the uninformed for the same reason as above (NPV negative). Since the informed have too little cash, the IPO will fail, which is bad since it was an NPV-positive project.

Question 15

What are other explanations than the winner’s curse for IPO underpricing?

Answer 15

• signal of high quality
• agency problems (between IPO firm and its underwriter)
• investor sentiments.

Question 16

What are the results of subscribing to IPOs on average?

Answer 16

Positive no matter economic conditions.

• Non-insider traders are often not bound by lock-up periods and can sell on the first day.
• For us to expect a positive return if we invest in all IPOs, we must invest proportionally across the IPOs (what data is based on).

Question 17

How is the contractual interest rate calculated?

Answer 17

Calculated assuming there is no default (often called only interest rate).

D/F -1

Question 18

How is the cost of capital calculated?

Answer 18

Calculated using the actual expected repayment (often called return).

Cash outflow/cash inflow -1

Question 19

In general, when a bank cannot perfectly assess the riskiness of its borrowers, how does a bank’s profit relate to D (promised repayment)?

Answer 19

Profits increase in D (as long as quality of borrower pool stays constant)

Question 20

How can market failure play out in a borrowing/lending market?

Answer 20

Financial frictions stemming from information asymmetry can prevent positive NPV projects from being financed.

• Lenders cannot distinguish between safe and risky borrowers.
• Lenders charge a high interest rate in case they are matched with risky borrowers.
• The interest rate is too high for safe borrowers, which implies that safe borrowers do not receive loans.

Question 21

How can we summarise the lemon problem in relation to M&M?

Answer 21

• Adverse selection can limit how much financing a firm can raise (not all NPV-positive investments can be made).
• The lemon problem can be partially overcome via: Screening & Signaling
• Costly collateral can be used as a signaling mechanism.
• Equity held by informed insiders can be used as a signaling mechanism (capital structure is not irrelevant).
• Financing and payout decisions are no longer irrelevant because they convey information.