What Is Asymmetric Information?

Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

Understanding Asymmetric Information

Asymmetric information exists in certain deals with a seller and a buyer whereby one party is able to take advantage of another. This is usually the case in the sale of an item. For example, if a homeowner wanted to sell their house, they would have more information about the house than the buyer. They might know some floorboards are creaky, the home gets too cold in winter, or that the neighbors are too loud; information that the buyer would not know until after they purchased the house. The buyer, then, might feel they paid too much for the house or would not have purchased it at all if they had this information beforehand.

Asymmetric information can also be viewed as the specialization and division of knowledge, as applied to any economic trade. For example, doctors typically know more about medical practices than their patients. After all, physicians have extensive medical school educational backgrounds that their patients generally don’t have. This principle equally applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other trained professionals. Asymmetric information, therefore, is most often beneficial to an economy and a society in increasing efficiency.

Advantages and Disadvantages of Asymmetric Information

Advantages

Asymmetric information isn’t necessarily a bad thing. In fact, growing asymmetrical information is the desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields.

For example, a stockbroker’s knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks to prepare for retirement. On the flip side, the stockbroker does not need to know how to grow crops or tend to livestock to feed themself, but rather can purchase the items from a grocery store that are provided by the farmer.

In each of their respective trades, both the farmer and the stockbroker hold superior knowledge over the other, but both benefit from the trade and the division of labor.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However, this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.

Disadvantages

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy’s sale.

For example, if the insured hides the fact that they’re a heavy smoker and frequently engage in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly disclosed risk profiles.

Special Considerations

To prevent abuse of customers or clients by finance specialists, financial markets often rely on reputation mechanisms. Financial advisors and fund companies that prove to be the most honest and effective stewards of their clients’ assets tend to gain clients, while dishonest or ineffective agents tend to lose clients, face legal damages, or both.

What Is an Assignment?

Assignment most often refers to one of two definitions in the financial world:

1. The transfer of an individual’s rights or property to another person or business. This concept exists in a variety of business transactions and is often spelled out contractually.
2. In trading, assignment occurs when an option contract is exercised. The owner of the contract exercises the contract and assigns the option writer to an obligation to complete the requirements of the contract.

Property Rights Assignment

Assignment refers to the transfer of some or all property rights and obligations associated with an asset, property, contract, etc. to another entity through a written agreement. For example, a payee assigns rights for collecting note payments to a bank. A trademark owner transfers, sells, or gives another person interest in the trademark. A homeowner who sells their house assigns the deed to the new buyer.

To be effective, an assignment must involve parties with legal capacity, consideration, consent, and legality of object.

Examples

A wage assignment is a forced payment of an obligation by automatic withholding from an employee’s pay. Courts issue wage assignments for people late with child or spousal support, taxes, loans, or other obligations. Money is automatically subtracted from a worker’s paycheck without consent if they have a history of nonpayment. For example, a person delinquent on $100 monthly loan payments has a wage assignment deducting the money from their paycheck and sent to the lender. Wage assignments are helpful in paying back long-term debts.

Another instance can be found in a mortgage assignment. This is where a mortgage deed gives a lender interest in a mortgaged property in return for payments received. Lenders often sell mortgages to third parties, such as other lenders. A mortgage assignment document clarifies the assignment of contract and instructs the borrower in making future mortgage payments, and potentially modifies the mortgage terms.

A final example involves a lease assignment. This benefits a relocating tenant wanting to end a lease early or a landlord looking for rent payments to pay creditors. Once the new tenant signs the lease, taking over responsibility for rent payments and other obligations, the previous tenant is released from those responsibilities. In a separate lease assignment, a landlord agrees to pay a creditor through an assignment of rent due under rental property leases. The agreement is used to pay a mortgage lender if the landlord defaults on the loan or files for bankruptcy. Any rental income would then be paid directly to the lender.

Options Assignment

Options can be assigned when a buyer decides to exercise their right to buy (or sell) stock at a particular strike price. The corresponding seller of the option is not determined when a buyer opens an option trade, but only at the time that an option holder decides to exercise their right to buy stock. So an option seller with open positions is matched with the exercising buyer via automated lottery. The randomly selected seller is then assigned to fulfill the buyer’s rights. This is known as an option assignment.

Once assigned, the writer (seller) of the option will have the obligation to sell (if a call option) or buy (if a put option) the designated number of shares of stock at the agreed-upon price (the strike price). For instance, if the writer sold calls they would be obligated to sell the stock, and the process is often referred to as having the stock called away. For puts, the buyer of the option sells stock (puts stock shares) to the writer in the form of a short-sold position.

Example

Suppose a trader owns 100 call options on company ABC’s stock with a strike price of $10 per share. The stock is now trading at $30 and ABC is due to pay a dividend shortly. As a result, the trader exercises the options early and receives 10,000 shares of ABC paid at $10. At the same time, the other side of the long call (the short call) is assigned the contract and must deliver the shares to the long.

What Are Assets Under Management (AUM)?

Assets under management (AUM) is the total market value of the investments that a person or entity manages on behalf of clients. Assets under management definitions and formulas vary by company.

In the calculation of AUM, some financial institutions include bank deposits, mutual funds, and cash in their calculations. Others limit it to funds under discretionary management, where the investor assigns authority to the company to trade on their behalf.

Overall, AUM is only one aspect used in evaluating a company or investment. It is also usually considered in conjunction with management performance and management experience. However, investors often consider higher investment inflows and higher AUM comparisons as a positive indicator of quality and management experience.

Understanding Assets Under Management

Assets under management refers to how much money a hedge fund or financial institution is managing for their clients. AUM is the sum of the market value for all of the investments managed by a fund or family of funds, a venture capital firm, brokerage company, or an individual registered as an investment advisor or portfolio manager.

Used to indicate the size or amount, AUM can be segregated in many ways. It can refer to the total amount of assets managed for all clients, or it can refer to the total assets managed for a specific client. AUM includes the capital the manager can use to make transactions for one or all clients, usually on a discretionary basis.

For example, if an investor has $50,000 invested in a mutual fund, those funds become part of the total AUM—the pool of funds. The fund manager can buy and sell shares following the fund’s investment objective using all of the invested funds without obtaining any additional special permissions.

Within the wealth management industry, some investment managers may have requirements based on AUM. In other words, an investor may need a minimum amount of personal AUM for that investor to be qualified for a certain type of investment, such as a hedge fund. Wealth managers want to ensure the client can withstand adverse markets without taking too large of a financial hit. An investor’s individual AUM can also be a factor in determining the type of services received from a financial advisor or brokerage company. In some cases, individual assets under management may also coincide with an individual’s net worth.

Calculating Assets Under Management

Methods of calculating assets under management vary among companies. Assets under management depends on the flow of investor money in and out of a particular fund and as a result, can fluctuate daily. Also, asset performance, capital appreciation, and reinvested dividends will all increase the AUM of a fund. Also, total firm assets under management can increase when new customers and their assets are acquired.

Factors causing decreases in AUM include decreases in market value from investment performance losses, fund closures, and a decrease in investor flows. Assets under management can be limited to all of the investor capital invested across all of the firm’s products, or it can include capital owned by the investment company executives.

In the United States, the Securities and Exchange Commission (SEC) has AUM requirements for funds and investment firms in which they must register with the SEC. The SEC is responsible for regulating the financial markets to ensure that it functions in a fair and orderly manner. The SEC requirement for registration can range between $25 million to $110 million in AUM, depending on several factors, including the size and location of the firm.

Why AUM Matters

Firm management will monitor AUM as it relates to investment strategy and investor product flows in determining the strength of the company. Investment companies also use assets under management as a marketing tool to attract new investors. AUM can help investors get an indication of the size of a company’s operations relative to its competitors.

AUM may also be an important consideration for the calculation of fees. Many investment products charge management fees that are a fixed percentage of assets under management. Also, many financial advisors and personal money managers charge clients a percentage of their total assets under management. Typically, this percentage decreases as the AUM increases; in this way, these financial professionals can attract high-wealth investors.

Real-Life Examples of Assets Under Management

When evaluating a specific fund, investors often look at its AUM since it functions as an indication of the size of the fund. Typically, investment products with high AUMs have higher market trading volumes making them more liquid, meaning investors can buy and sell the fund with ease.

SPY

For example, the SPDR S&P 500 ETF (SPY) is one of the largest equity exchange-traded funds on the market. An ETF is a fund that contains a number of stocks or securities that match or mirror an index, such as the S&P 500. The SPY has all 500 of the stocks in the S&P 500 index.

As of Mar. 11, 2022, the SPY had assets under management of $380.7 billion with an average daily trading volume of 113 million shares. The high trading volume means liquidity is not a factor for investors when seeking to buy or sell their shares of the ETF.

EDOW

The First Trust Dow 30 Equal Weight ETF (EDOW) tracks the 30 stocks in the Dow Jones Industrial Average (DJIA). As of Mar. 11, 2022, the EDOW had assets under management of $130 million and much lower trading volume compared to the SPY, averaging approximately 53,000 shares per day. Liquidity for this fund could be a consideration for investors, meaning it could be difficult to buy and sell shares at certain times of the day or week.

What is Asset Valuation?

Asset valuation is the process of determining the fair market or present value of assets, using book values, absolute valuation models like discounted cash flow analysis, option pricing models or comparables. Such assets include investments in marketable securities such as stocks, bonds and options; tangible assets like buildings and equipment; or intangible assets such as brands, patents and trademarks.

Understanding Asset Valuation

Asset valuation plays a key role in finance and often consists of both subjective and objective measurements. The value of a company’s fixed assets – which are also known as capital assets or property plant and equipment – are straightforward to value, based on their book values and replacement costs. However, there’s no number on the financial statements that tell investors exactly how much a company’s brand and intellectual property are worth. Companies can overvalue goodwill in an acquisition as the valuation of intangible assets is subjective and can be difficult to measure.

Net Asset Value

The net asset value – also known as net tangible assets – is the book value of tangible assets on the balance sheet (their historical cost minus the accumulated depreciation) less intangible assets and liabilities – or the money that would be left over if the company was liquidated. This is the minimum a company is worth and can provide a useful floor for a company’s asset value because it excludes intangible assets. A stock would be considered undervalued if its market value were below book value, which means the stock is trading at a deep discount to book value per share.

However, the market value for an asset is likely to differ significantly from book value – or shareholders’ equity – which is based on historical cost. And some companies’ greatest value is in their intangible assets, like the findings of a biomedical research company.

Absolute Valuation Methods

Absolute value models value assets based only on the characteristics of that asset. These models are known as discounted cash flow (DCF) models, and value assets like stocks, bonds and real estate, based on their future cash flows and the opportunity cost of capital. They include:

• Discounted dividend models, which value a stock’s price by discounting predicted dividends to the present value. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued.
• Discounted free cash flow models calculate the present value of future free cash flow projections, discounted by the weighted average cost of capital.
• Residual income valuation models consider all the cash flows that accrue to the firm post the payment to suppliers and other outside parties. The value of the company is the sum of book value and the present value of expected future residual income. Residual income is calculated as net income less a charge for the cost of capital. The charge is known as the equity charge and is calculated as the value of equity capital multiplied by the cost of equity or the required rate of return on equity. Given the opportunity cost of equity, a company can have positive net income but negative residual income.
• Discounted asset models value a company by calculating the present market value of the assets it owns. As this method does not take into account any synergies, it’s only useful for valuing commodity businesses like mining companies.

Relative Valuation & Comparable Transactions

Relative valuation models determine the value based on the observation of market prices of similar assets. For example, one way of determining the value of a property is to compare it with similar properties in the same area. Likewise, investors use the price multiples comparable public companies trade at to get an idea of relative market valuations. Stocks are often valued based on comparable valuation metrics such as the price-to-earnings ratio (P/E ratio), price-to-book ratio or the price-to-cash flow ratio.

This method is also used to value illiquid assets like private companies with no market price. Venture capitalists refer to valuing a company’s stock before it goes public as pre-money valuation. By looking at the amounts paid for similar companies in past transactions, investors get an indication of an unlisted company’s potential value. This is called precedent transaction analysis.

Real World Example of Asset Valuation

Let’s work out net asset value for Alphabet Inc. (GOOG), the parent company of search engine and advertising giant Google.

All figures are for the period ending Dec. 31, 2018.

• Total assets: $232.8 billion
• Total intangible assets: $2.2 billion
• Total liabilities: $55.2 billion

Total net asset value: $175.4 billion (total assets $232.8 billion – total intangible assets $2.2 billion – total liabilities $55.2 billion)