A:

Financial markets exhibit asymmetric information in that in a financial transaction, one of the two parties involved will have more information than the other and will have the ability to make a more informed decision.

When it comes to the purchase or sale of a financial security, asymmetric information occurs when either the buyer or seller has more information on the past, present or future performance of that financial security. If the buyer has more information, he knows that the security is underpriced relative to its aggregate performance. If the seller has more information, he knows that the security is overpriced relative to its aggregate performance. Asymmetric information gives either the buyer or seller a better opportunity to make a profit over the purchase or sale of a financial security.

When it comes to borrowing or lending money, asymmetric information occurs when the borrower has more information about his financial state than the lender does. The lender is more unsure whether the borrower will default on the loan. The lender can look at a borrower's credit history and salary levels, but this provides limited information compared to what the borrower knows about his own financial situation. To account for this asymmetric information, a lender will charge a risk premium to compensate for the disparity in information.

Asymmetric information can lead to either moral hazard or adverse selection. Moral hazard occurs when a party will take a risk because the cost of the risk won't be felt by that party. Adverse selection is a process that occurs when undesired results happen because of buyers and sellers have access to different information. Both moral hazard and adverse selection result in market failures.

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