Types of financial market failure?

Question 1

What are the different types of financial market failure?

Answer 1

• Speculation and market bubbles
• asymmetric information - moral hazard and adverse selection

Question 1

What is speculation?

Answer 1

When assets are bought at a low price and sold at a high price

Question 2

What is the risk with speculation?

Answer 2

• the asset could fall in value, making your profit making ideal erode
• What if they are a leverage deal

Question 3

What is a leverage deal? What is the risk/ problem of this?

Answer 3

• Borrowing to amplify the outcome of your deal.
• the borrowing could create a bubble into making people thinking prices will be high in the end, which may be unrealistic and doesn’t happen.

Question 4

How does leveraged deals which lead to bubbles occur?

Answer 4

• the demand for the assets fall, people who borrowed money and are sitting on these assets panic and try to sell them as quickly as possible as their assets are becoming worthless.
• Bank and individual at risk

Question 5

What is moral hazard? Example?

Answer 5

• A decision that goes bad making the third party pay.
• Banks think they are too big to fail

Question 6

How does asymmetric information occur?

Answer 6

• banks will know what they are doing, the new derivatives which they can hide from regulators and the government.

Question 7

What is adverse risk?

Answer 7

When the most likely buyers of a product are those buyers sellers would prefer not to sell to.

Question 8

How does asymmetric information lead to adverse risk? Example?

Answer 8

• excessive risk is taken as they are the worst kind of buyers and potential collapse of financial institutions
• the premiums issued by health insurance companies will be based on who they think are most likely to buy. the problem is the consumers will think the deal is bad, whereas bad consumers will think the deal is good and they’ll buy. Bad as they are costly. Risks profits and means prices can’t go up.

Question 9

How does negative externalities lead to failure?

Answer 9

• cost to tax payer for bailouts
• loss of savings
• lost jobs, income, growth

Question 10

Market rigging definition

Answer 10

Where traders/bankers/intermediaries collude to manipulate markets and to make huge profits.

Question 11

Examples of market rigging?

Answer 11

• LIBOR and FOREX markets were fixed
• rigging
• even if there are heavy fines and regulations, they can still occur if punishment and enforcement is weak