Assignmen

t1
Financial Intermediaries &
Investment Banking

Submitted To:
Prof. Qamar Abbas
Submiited By:
Khawaja Muahammad
Awais
L1F07BBAM2183
Think of an example in which you have to
deal with the adverse selection problem.
Adverse selection is one of the most celebrated phenomena in the
economics of information.

Adverse selection can also be seen in some scenarios involving the hiring of
independent contractors to perform certain types of work. For example,
suppose that a landlord owns a number of rental properties and wants to hire
someone to mow the lawns and do general yard maintenance for the
properties. In this case, further assume that the landlord has decided on a
predetermined amount that he is willing to pay per property for this work,
and this amount is well below current market value.

The landlord advertises the job and it is accepted by a contractor with very
little discussion on exactly what work should be performed. The landlord is
expecting a very high quality job to be done, and each yard to be
meticulously cared for. Based on the payment being offered, however, the
contractor assumes that the landlord only wants minimal yard work done
and only provides basic service.

Another example is the adverse selection in credit market. From large-scale

randomized tests in preapproved credit card collections for direct evidence
of adverse selection, four basic conclusions are reached. First, there is clear
evidence of adverse selection on observable information: respondents to
solicitations are substantially worse credit risks than nonrespondents.
Second, comparing the customer pools resulting from different offers,
solicitations offering inferior terms (e.g., a higher introductory interest rate, a
shorter duration to the introductory offer, or a higher post-introductory
interest rate) yield customer pools with worse observable credit-risk
characteristics than solicitations offering superior terms.

Third, there is also clear evidence of adverse selection on hidden

information: even after controlling for all information known by the card
issuer at the time the account is opened, customers who accept inferior
offers are significantly more likely to default. Fourth, recipients of credit card
solicitations appear to over respond to the introductory interest rate relative
to the duration of the introductory offer and to the post-introductory interest
rate, consistent with the author's “underestimation hypothesis” that
consumers may systematically underestimate the extent of their current and
future credit card borrowing.
"In a world without information and
transaction cost, financial intermediaries
would not exist." Is this statement true, false
or uncertain? Explain your answer.

It’s uncertain that without information and transaction costs financial

intermediaries would exist. That's exactly what had happened in the past.
The world is full of these intermediaries that sometimes do not create value
added but actually burdening the economies.

Even at this stage such job still exist BUT at least they provide value added
to the end user & the lender.

In a world with information but no transactional cost, it would depend on

what code of ethics you feel binds human beings. If it is the social contract
theory, there would still exist intermediaries to determine who gets what,
even if it was some point-based system to calculate merit. Otherwise, pure
carnage would ensue as everyone would stab to own a Ferrari. Without info,
Ferraris have no value.

Modern world would not have been so efficient, aggressive and progressive
without financial intermediation.

If lenders incur lower transaction costs by lending to an intermediary, such

as a bank,compared to lending directly to a borrower then lenders will
choose to lend to(deposit money with) a bank. Similarly, borrowers will
prefer to borrow from a bankif the information costs (mainly search costs)
are lower than direct borrowing. Financial intermediaries are able to reduce
transaction costs substantially because they have developed expertise and
because their large size enables them to take advantage of economies of
scale.

If there were no intermediaries, individual savers would have to directly

purchase the securities of borrowers. There would have been incompatibility
of the maturity needs of lenders and borrowers since most savers want to
lend funds at short maturity, while borrowers want to borrow at longer
maturities. It would have been difficult to match small amounts of individual
savings to the larger loan amounts desired by borrowers.

Financial intermediaries provide convenient and safe way to store finds and
creates standardized forms of securities. It also facilitates easy exchange of
funds. Due to high volume it is able to bear transaction and information
search cost on behave of savers. Therefore, individual saver enjoys financial
services that enable them to deposit and withdraw funds without negotiation
whereas borrower avoids having to deal with individual investors.

Since it has information available for both lenders and borrowers, it

minimizes information cost for analyzing their data. Without financial
intermediaries lenders and borrowers would have to pay higher transactional
and information costs.