3.

Information Asymmetry
a) If bond investors are able to distinguish investment-grade bond and junk food, there
is no information asymmetry in the bond market. So the equilibrium price will be
$ 95for investment-grade bond and $80 for junk bond.
b) If there exists information asymmetry, the valuation on a bond will be
Expected (VB) = fraction of junk bond*value of junk bond + fraction of investmentgrade bond*value of investment-grade bond
= * $80+ (1 - ) * $95 = 95 - 15
c) Equilibrium price = expected valuation on bond = 95 - 15*0.2 = $92
d) Comparing the equilibrium prices, the bond investors and issuer of investmentgrade bonds will be worse off.
1) The information asymmetry in the bond market increases the uncertainty for bond
investors because they do not know whether they purchase investment-grade bonds or
junk bonds.
2) The information asymmetry makes the market unfair for the issuers of investmentgrade bonds because they receive lower price than that in market without information
asymmetry.
3) Higher price of junk bonds motivates more issuers sell the junk bonds and it will
increase the fraction of junk bonds in the bond market.
e) Comparing the equilibrium prices, the bond issuers of junk bonds will be better off.
Because of information asymmetry, the expected valuation of bonds in the market
leads to higher pooled equilibrium price than the equilibrium price of junk bonds in
the market without information asymmetry, and the issuers of junk bonds earn more
money.
f) Expected valuation on a bond = 95 15*0.6 = $86
The valuation on a bond in the market $86 is lower than the price $90, the lowest
price which the issuers of investment-grade bonds can accept, then the sellers of
investment-grade bonds will quit the bond market. Besides, investors in the market
can acquire all information except the knowledge to distinguish the two kinds of
bonds so that all investors will realize that the rest of bond issued in the market are
junk bonds with high default probability. As a result, the bonds investors are willing to
pay only $80 for the all bonds and then the equilibrium price will be $80.
g) Due to the market failure, all participators in the bond market, including bond
investors, issuers of investment-grade bonds and issuers of junk bonds, will be worse
off.
1) All bond investors now can only purchase the junk bond with high default
probability and it prevent the investors who are willing to buy the investment-grade
bonds from participating in the bond market.
2) The market failure keeps away the issuers of investment-grade bonds because the
equilibrium price is lower than their acceptable price.
3) Comparing to the situation in the question c), the investors of junk food receive
lower price $80 than the equilibrium price $92 in c) because all investors in the
market realize that there only exist junk bonds in the market.
h) Credit-rating agencies provide the information which can help the investors

distinguish the investment-grade bonds and junk bonds, eliminating the information
asymmetry.
1) It guarantees that all participators in the bond market can obtain the opportunities
to issue or purchase their desirable bonds, which could maximize the social wellbeing.
2) With the information to distinguish the investment-grade bonds and junk bonds, the
equilibrium price can match the issuers of investment-grade bonds with risk-aversion
investors who intend to purchase bonds with low default risk, or the junk bonds with
investors who are willing to undertake more risk.
3) It rationalizes the market fairly that every investor receives the desirable bonds and
every issuer obtain more reasonable price, as well as eliminate the unreasonable
incentive to issue more junk bonds.