A situation in which the party with hidden information chooses to deal when the other side loses. Lenders face it when the riskiest borrowers are keenest to borrow.
Where you will meet it
Adverse selection comes up in 8 learning outcome notes across the FRM syllabus.
A few of them:
Banks FRM Part I · Financial markets and products
“Adverse selection is the tendency of risky banks to be the keenest to join.”
Operational Risk FRM Part I · Valuation and risk models
“Adverse selection arises before the policy is bought: firms that know their controls are weak or their risks high are the most eager to buy, and the insurer cannot observe this.”
Credit Scoring and Retail Credit Risk Management FRM Part II · Credit risk measurement and management
“There is also less cross-subsidy from low-risk to high-risk borrowers, and better protection against adverse selection by competitors that price on risk.”
Private Markets Investing (up to section 3.3.10) FRM Part II · Risk management and investment management
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