Theme 4.4.2 Flashcards
(10 cards)
Define market failure
when the free market mechanism fails to allocate resources efficiently, leading to suboptimal outcomes for society
Define asymmetric information
when one party in a transaction has more information than the other
Define adverse selection
Occurs when individuals with hidden information about their riskiness (e.g., borrowers with poor credit history) are more likely to seek financial products (e.g., loans). This can lead to higher default rates for lenders.
Define moral hazard
Arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information. For example, borrowers may take on excessive risks if they believe they won’t bear the full consequences of their actions.
Define externalities
the cost or benefit a third party receives from an economic transaction outside of the market mechanism
Externalities
Negative externalities: Financial institutions may engage in risky practices (e.g., excessive lending) that can lead to systemic risks affecting the entire economy. The 2008 financial crisis is an example of negative externalities - in order to prevent the collapse the Royal Bank of Scotland , the gov decided to bail out the bank for $45bn , which was mostly paid for by tax revenue .
Positive externalities: A well-functioning financial sector can benefit the broader economy by efficiently allocating capital and promoting economic growth.
Define moral hazard
refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their actions.
can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis. This can lead to reckless behavior and excessive risk-taking.
Speculation and Market Bubbles
Speculation involves buying assets (e.g., stocks or real estate) with the expectation of profiting from price increases, rather than from the asset’s intrinsic value.
Market bubbles occur when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance. Bubbles often burst, leading to market crashes and financial instability.
AO2 - The US housing market bubble
It was a market bubble that was blown up through poor lending decisions by banks.
Us banks would lend $to homeowners regardless of their ability to pay it back and they would do this because believed there was lots of money to be made from the interest.
When the bubble eventually burst because borrowers were unable to pay back the mortgages, the US sub-prime market collapsed - sparked 2008 financial crisis
Describe market rigging
refers to the manipulation of financial markets to gain unfair advantages.
E,g insider trading (trading based on non-public, material information), market manipulation (e.g., pump-and-dump schemes), and collusion among market participants to distort prices.
It undermines market integrity and can lead to investor losses.
