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When one party in a transaction has more information than the other side, the phenomenon known as "adverse selection" in finance and economics results, which is negative for the second party. In markets where there is knowledge asymmetry between buyers and sellers, adverse selection can become an issue.
Adverse selection can result in market inefficiencies and less-than-ideal results for investors in the setting of financial markets. Adverse selection, for instance, can happen in the insurance industry when people who have a higher chance of filing a claim buy insurance while people who have a lesser chance of filing a claim don't. Due to the greater predicted claims of the higher-risk category, insurance companies may increase premiums for all insurance customers as a result.
When lenders have insufficient knowledge about potential borrowers' creditworthiness, adverse selection can also occur in the context of financial intermediation. This may lead to the denial of credit to borrowers who are creditworthy and the extension of credit to those who have a higher chance of default.
Different strategies, such as the use of credit rating, collateral, and securitization, have been devised to lessen the consequences of adverse selection. Lenders utilize credit scoring, a statistical technique, to evaluate potential borrowers' creditworthiness using a variety of financial and non-financial factors. A collateral is a security offered to a lender by a borrower to secure a loan, lowering the lender's risk of default. The act of pooling and repackaging assets, such as loans, into tradable securities, is known as securitization. This procedure allows the lender to transfer risk to the investor.
