Asymmetric Information Definition

Asymmetric information occurs when information is held by one, but not all, of the parties to a transaction.

Asymmetric Information Example

For example, consider a potential buyer of Company XYZ shares and the seller of those shares. If the seller knows the CFO's brother-in-law and has heard that the company is facing undisclosed financial problems, then the seller has asymmetric information.

In this case, the seller might want to sell his or her shares before the news became available to the public. Once the company's problems are made public, it is likely that the shares will plummet, causing anyone who owns stock in XYZ to lose money. Essentially, the seller is taking advantage of the buyer's lack of knowledge.

Although the example above is an example of getting the best of someone for personal profit, in a lot of cases it is beneficial for the side with asymmetric information to give their information away in order to complete a transaction. Job applicants are good examples of this -- they must signal their skills and information to the hiring party in order to encourage a job offer. Otherwise, the employer would not know what the employee has to offer.

Why Does Asymmetric Information Matter?

Although the existence of asymmetric information is debated, the presumption of the existence of asymmetric information in the markets is often why some investors simply invest in index funds and mutual funds, which simply diversify the investor's money across a host of investments. Other investors 'get in the game' by investing in hedge funds and other securities run by those with access to that asymmetric information.

In any case, most analysts agree that asymmetric information is harder to come by in developed markets because technology has made information dissemination increasingly ubiquitous and timely. Nonetheless, it is important to note that not all information is good information; that is, just having information that others don't have doesn't necessarily make that information valuable or even correct. Additionally, it is important to be aware that trading on asymmetric information may be illegal.