Adverse selection

What it means

The problem that arises when the party with better information self-selects into a transaction, leaving the counterparty with the worse risks.

The exam angle

Distinct from moral hazard: adverse selection happens before the contract, moral hazard after it.

Where it appears in the syllabus

• EconomicsCFA Level I · exam weight 6–9% · Market structures, business cycles, policy, trade and exchange rates.
• Foundations of Risk ManagementFRM Part I · exam weight 20% · Risk taxonomy, governance, CAPM, multifactor models, financial disasters.
• Credit Risk Measurement & ManagementFRM Part II · exam weight 20% · Merton and reduced-form models, credit VaR, counterparty risk, CVA, CDOs.

Related terms

• InflationA sustained rise in the general price level, reducing the purchasing power of money.
• Monetary policyA central bank’s management of money supply and interest rates to pursue price stability and, in some mandates,…
• Moral hazardThe incentive to take more risk once someone else bears the consequences.
• Business cycleThe recurring pattern of expansion, peak, contraction and trough in economic activity.
• Core inflationInflation excluding food and energy prices, which are volatile and often driven by supply rather than demand.
• Fiscal policyGovernment use of spending and taxation to influence aggregate demand.