Definition: Asymmetric information, or information asymmetry, occurs when one party in a transaction has greater information about the topic at hand than the other party.
What Does Asymmetric Information Mean?
What is the definition of asymmetric information? is usually present when the seller of a good or a service knows more about the product or the service than the buyer. For instance, a car retailer has full knowledge of the capabilities of a particular model than a buyer. So, the buyer has to trust the car seller in order to know all the details about the vehicle he is interested in buying.
In capital markets, information asymmetry occurs because the borrowers have a full knowledge of their financial situation. Therefore, before approving a loan, a financial institution should perform due diligence to make sure that the borrower is reliable and unlikely to default on the loan. However, a credit history check or a salary verification provides limited information about the borrower’s financial state. Hence, there is information asymmetry, and the bank charges a risk premium in case the borrower defaults.
Let’s look at an example.
Example
Mary wants to buy 500 shares of Company ABC, a leading construction company. Mark has 500 shares of Company ABC that he wants to sell because he has inside information that the company is about to go bankrupt. Since Mark has more information on the company’s true financial situation, there is information asymmetry, and he can capitalize on this information to avoid losses. On the other hand, Mary, who is not aware of the possibility of the company’s bankruptcy, is more likely to lose her money on the stocks.
If Mark does not sell his shares, and the company’s financial problems become public, he will lose more money because the stock price will decline sharply, causing all stockholders of Company ABC to lose their money. Therefore, Mark, should take advantage of the inside information and sell his shares before the entire market acquires a full knowledge of the company’s financial situation.
Summary Definition
Define Asymmetric Information: Information asymmetry means one side of a transaction is better informed about the terms and significance of the transaction than the other.
