Asymmetric Information - Article Example

(investopedia.com) v. Interest Rate Swap - An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is'linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

(Investopedia.com) 2. The general law of tradeable goods which says that the good will be sold at the same price regardless of where it is produced is called The Law of One Price. The law of one price says that goods will be sold at the same price whether it is produced in India or in U.S. The difference in their selling price will be reflected by the nominal exchange rate. In this respect, the nominal exchange rate will adjust so as one good can be bought at the same price using different currencies. 3. In mathematics, it will be shows as:1/P = e/P* where P is the local price, P* is the foreign price and e is the nominal exhange rate.

From this we see that equality will be manitaines if e adjusts to whatever the value of P and P*are.3. Interest Rate Parity - A second principle, Interest Rate Parity, ties the interest rates of two nations with their exchange rates.' According to the Interest Rate Parity principle, the difference in similar nominal or market rates of interest should be equal to the forward premium of the nation with the lower inflation rate.' Otherwise arbitrage will occur, the profitability of which will cease only when interest rate parity once again prevails.

(http://byrned.faculty.udmercy.edu/) As seen in the graph, an increase in the foreign interest rate will lessen the demand for domestic assets. Thus the demand curve shifts to the left. The shift of the demand curve to the left, causes a change in the equilibrium point. With the new equilibrium point, the returns from expected asset holdings declines and the exchange rate also declines. This means that the domestic currency weakens. Using the law of demand, we know that as the foreign interest rate (thus returns) increases, more will demand foreign currency instead of domestic currency.

Thus it's value declines. 4. There are two problems that arise from asymmetric information: the adverse selction and the moral hazard problem. Adverse Selection - Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information (i.e. access to different information): the "bad" products or customers are more likely to be selected.

A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its low-balance, high-activity (and hence least profitable) customers. (Wikipedia.com)Moral hazard - Moral hazard is a special case of information asymmetry, a situation in which one party in a transaction has more information