ï»¿UNIVERSITY OF SUNDERLAND
ASSESSMENT COVER SHEET / FEEDBACK FORM
BA (HONS) BANKING AND FINANCE
Table of Contents
ASSESSMENT COVER SHEET / FEEDBACK FORM 1
Question 1 4
Explain what you understand by the following terms relating to the financial markets. 4
With close reference to your answer in part (a), critically discuss why there is a need to regulate financial markets. How might financial marketsâ€™ regulations be implemented? 8
Question 2: Distinguish between spot and forward exchange rates and explain how these rates are determined in foreign exchange markets. Critically examine the relationship ...view middle of the document...
1. Asymmetric information:
Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power (Howell, 2010). For example, when you are trying to negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not know the minimum you will be willing to accept.
Asymmetric information may lead to adverse selection and moral hazard.
Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of goods or services in a market to shift. This results in "bad" products or services being selected (Howell, 2010). For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers. The individual price would generate a low profit for the bank.
2. Moral Hazard:
Moral hazards are a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk. A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk (Howell, 2010). For example, moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision making will occur.
Another example for Moral Hazard:
Investors who invested their funds with Bernard Madoff lost most of their $65 billion because Madoff was running a Ponzi scheme rather than investing the money as the investors intended, paying people who were withdrawing their money with money received from new investors. Madoff had not actually invested any of his client's money for years. During the 2008 credit crisis, more money was being withdrawn than was coming in, so the Ponzi scheme finally collapsedâ€”decades after it began (Spaulding, 2014).
People who invested in American International Group (AIG) thought that their money was relatively safe because they were investing in an insurance company that had the highest credit rating given by the credit rating agencies. However, AIG was also selling credit default swaps on mortgage-backed securities (MBSs) that started to default in large numbers in 2008 requiring them to post more collateral than they had. Why did AIG take such risks? Because the traders who sold the credit default swaps (CDSs) were receiving huge bonuses and they...