Give a concrete example of adverse selection and moral hazard in financial markets

Adverse Selection

Adverse selection presents a case where asymmetric information is exploited. In this case, one entity enjoys more information than the other entity during a transaction. Consider, for example, a case where a seller knows more concerning the product's quality than the buyer. This information failure means that one party enjoys more material knowledge than the other transacting party.

Example

Adverse selection occurs when a party seeking insurance cover hides some important information from the insurance provider. The insured understands that this information can influence his or her risk profile and ultimately determine his or her premiums.

Moral Hazard:

Moral hazard references a situation in which a party enjoys an incentive to take high risks because the risk-taking party is fully protected against risks and losses. In most cases, the other party in the agreement bears the full cost of loss. This situation, just like adverse selection, arises as a consequence of information asymmetry.

Example

In financial markets, there exists a risk that borrowers might engage in high-risk actions because such actions render him less likely to service the debt. The borrower, in this case, understands that the lender will have to pay for his mistakes. This encourages him to take part in risk endeavors.