Journal of Finance2014-09-28 4:57 PM



Numerous markets are characterized by informational differences between buyers and sellers. In financial markets, informational asymmetries are particularly pronounced. Borrowers typically know their collateral, industriousness, and moral rectitude better than do lenders; entrepreneurs possess “inside” information about their own projects for which they seek financing.

Lenders would benefit from knowing the true characteristics of borrowers. But moral hazard hampers the direct transfer of information between market participants. Borrowers cannot be expected to be entirely straightforward about their characteristics, nor entrepreneurs about their projects, since there may be substantial rewards for exaggerating positive qualities. And verification of true characteristics by outside parties may be costly or impossible.

Without information transfer, markets may perform poorly. Consider the financing of projects whose quality is highly variable. While entrepreneurs know the quality of their own projects, lenders cannot distinguish among them. Market value, therefore, must reflect average project quality. If the market were to place an average value greater than average cost on projects, the potential supply of low quality projects may be very large, since entrepreneurs could foist these upon an uninformed market (retaining little or no equity) and make a sure profit. But this argues that the average quality is likely to be low, with the consequence that even projects which are known (by the entrepreneur) to merit financing cannot be undertaken because of the high cost of capital resulting from low average project quality. Thus, where substantial information asymmetries exist and where the supply of poor projects is large relative to the supply of good projects, venture capital markets may fail to exist.

Full Article





Journal of Finance

The Journal of Finance publishes leading research across all the major fields of financial research. It is the most widely cited academic journal on finance.

0 Following 12 Fans 0 Projects 72 Articles


AbstractWe study the performance of nearly 1,400 U.S. buyout and venture capital funds using a new data set from Burgiss. We find better buyout fund per

Read More

Abstract:During the past few decades, the fraction of the equity market owned directly by individuals declined significantly. The same period witnessed

Read More

Abstract:We propose a new definition of skill as general cognitive ability to pick stocks or time the market. We find evidence for stock picking in b

Read More

Abstract:We investigate the relationship between ex ante total skewness and holding returns on individual equity options. Recent theoretical developm

Read More

Abstract:We establish that CEOs of companies experiencing volatile industry conditions are more likely to be dismissed. At the same time, accounting

Read More

Abstract:Defining and measuring readability in the context of financial disclosures becomes important with the increasing use of textual analysis and

Read More

Abstract:Contrary to recent accounts of off-balance-sheet securitization by financial firms, we show that asset securitization by nonfinancial firms

Read More

Abstract:To rationalize the well-known underperformance of the average actively managed mutual fund, we exploit the fact that retail funds in differe

Read More

 The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs abou

Read More

AbstractOne of the problems which has plagued those attempting to predict the behavior of capital markets is the absence of a body of positive microeco

Read More