Asymmetric Information in Financial Markets

Question: What is the purpose and objectives of corporate governance, and the principles on which it is based.? An explanation of what is meant by rules-based and principles-based approaches to corporate governance, identifying the arguments for each approach.? What advantages might the company gain through the appointment of non executive directors? Explain the importance of board committees in corporate governance.? An Identification of three of the committees frequently established in organisations and explain their purpose.? Answer: Agency dilemma, in a better way is known as principal-agent problem (Malcomson Spinnewyn, 2004). It may be stated that, this is that particular situation that arise when an individual or the agent is able enough to take and make pronouncement on the behalf of and that which has an impact on the other person or the agent, who is the principal. Sometimes there arises a quandary, mainly because in certain cases the agent is induced to act in several ways that might suit his best interest, rather than adhering to the importance of the principal. Therefore, it is evidently stated that, this principal-agent relation is a very functional and constructive apparatus in not only political science and economics but also applicable to other areas. Source: [blog.design-squared.eu] On the way to get a detailing on this issue of principal-agent problem, very common examples that can be cited are of shareholders (principal) and corporate management (agent), voters (principal) and politicians (agent). The crisis crops up when the two existent parties, i.e, the principal and the agent, have asymmetric information and unlike interests (Thomas, 2004). Due to this asymmetric information, where the agent is supposedly believed to have more part of the information, the principal anyway feels that the agent is acting keeping in mind his or her own perspectives and interests. In this particular kind of scenario, some clash of interests and ethical hazard might arise, the reason being that the principal is in most of the cases at the risk and probability of getting exploited by the agent. As a result of this grave situation, the principal might try to avoid any kind of deal with the agent. But, actually the transaction would have also been a fruitful one, serving the inter ests of both the parties. As a matter of fact here lie the disadvantages of the Asymmetric information (Bebczuk, 2003). This obvious deviation from the interest of the principal on the part of the agent is termed as Agency costs Source: [www.wikispaces.com] Source: [wiki.wooster.edu] As such, there are several means that may be utilized in the alignment of the interests of the agents with that of the principal. For example, in employment, the employers who are the principal use tools like profit sharing, piece rates/commissions, efficiency wages, or even the threat of employment termination. The concept and theory of principal and agent came into being in the 1970s, as a result of combination of disciplines of the institutional theory and economics (Tihanyi, et.al, 2012). In the perspective of law, perhaps the principals are not aware of the fact that whether a contract has at all been satisfied or not, the result of which is that they finish up with the so called agency costs (Chernenko, et.al.,2010) Source: [www.slideplayer.com] The lack of information that leads to agency problem can also be depicted in a more relevant way as below. Source: [www.tutor2u.net] The issue of principal agent problem basically revolves around the central agenda of how to get more of the workers who are the principal in favor of the agents who are the employers. The discussions on the following points may help in getting a better understanding: Ownership and control In case of any private concern, the owners what they do is elect the board of directors, who in turn exercise control over the business resources available for them. But, there may arise situations, where the owner of the company has to sell some of the shares of the company or take out some bonds. It is at this juncture that, the authority might lose some of the allotted powers. The other stakeholders might exercise their right to votes where the loan providers very often have some authority over the business assets (Friedman Miles, 2006). A disagreement may be caused here due to the presence of several shareholders, who in turn have different targets (Claessens, 2011). Employee share ownership schemes A wide spectrum of strategies is present for dealing with the issue of principal-agent problem. One such strategy is the growth of employee share ownership plans (Chamberlain, et.al., 2009) But the usage and mishandling of share alternative has been a controversial topic over several years now. Designing of contract In order to reduce and manage the economic tussle, the principals and agents need to design and agree on a specified contract. This contract acts as a blueprint and guide in order to safeguard the best of interests of the parties, i.e, principal and the agent. The given equation is used to establish incentive compensation in a contract (Gomez-Mejia Werner, 2008): w= a+ b (e+ x+ gy), where, w= wage, a= constant, e= observed effort, x= unobserved exogenous result and its effects, y= observed exogenous effects, g and a stand for the weight given to y, and the income base. A contract related to business eventually creates an easy association between the performances of the agents and the net effectiveness. Overall, it is said that this relation is the parameter for judging the agent performance. Performance evaluation In any kind of business relationships, it is the principal who uses the evaluations based on performances to assure that the agent on his part is fulfilling the required responsibilities (John Eeckhout, 2006). Performance estimation can be of two types: Subjective performance evaluation- In this, it is the principal who directly evaluates the performance of the agent. The judgment in case of subjective performance evaluation is based on opinions (Prince, 2007). Objective performance evaluation- This particular evaluation is based on the comparison that is made with the performance of the agent with that of the work that has been finished by peers inside the business (Stufflebeam, 2001). Incentive structures The structure of incentives is a very crucial part of any business relationship. It is this that forms a viaduct between the interests of the agent and the principal (Moro, et.al., 2005). The principal propose various deals that in turn act as a motivating factor to the agents so that they work efficiently. Therefore, to conclude, it can be inferred from the above made discussions that, the principal-agent problem, that is also known as agency dilemma subsists in any business set up where there is a difference of interests between the agents and the principals. References Bebczuk, R. (2003). Asymmetric information in financial markets. Cambridge, UK: Cambridge University Press. Chamberlain, C., Ife, M., Chamberlain, C. (2009). Employee share schemes. Haywards Heath: Tottel. Chernenko, S., Foley, C., Greenwood, R. (2010). Agency costs, mispricing, and ownership structure. Cambridge, MA: National Bureau of Economic Research. Claessens, S. (2011). Expropriation of minority shareholders (3rd ed.). Washington, DC: World Bank. Friedman, A., Miles, S. (2006). Stakeholders. Oxford: Oxford University Press. Gomez-Mejia, L., Werner, S. (2008). Global compensation. London: Routledge. John, L., Eeckhout, L. (2006). Performance evaluation and benchmarking. Boca Raton, FL: CRC Press. Malcomson, J., Spinnewyn, F. (2004). The multiperiod principal agent problem (3rd ed.). Southampton: University of Southampton. Moro, G., Sartori, C., P. Singh, M. (2005). Agents and Peer-to-Peer Computing. Berlin: Springer. Prince, M. (2007). A model for subjective evaluation of performance (2nd ed.). Windsor, Ont.: University of Windsor, Faculty of Business Administration. Stufflebeam, D. (2001). Evaluation models. San Francisco: Jossey-Bass. Thomas, J. (2004). Income fluctuation and asymmetric information (3rd ed.). Reading, Berks[hire], UK: Dept. of Economics, University of Reading. Tihanyi, L., Devinney, T., Pedersen, T. (2012). Institutional theory in international business and management. Bingley, U.K.: Emerald.