Capital market imperfections are limitations that reduce the range of financial contracts that can be signed or honored. These restrictions are more common in capital markets. There are three basic reasons for that: First, lenders do not have full information about the borrower, whether they have the capacity to pay back their debt and/or whether they are willing to pay (asymmetric information). Secondly, the lender needs to trust the borrower to commit and to pay back his/her debt or there needs to be a third party to enforce the contract as it is more difficult to enforce contracts ex post (limited commitment). Finally, since the exchange does not happen at the same time, there is always room for renegotiation. Perfect capital markets In perfect capital market case, assuming complete markets, perfect rationality of agents and under full information, the equilibrium occurs where the interest rates clear the market, with the supply of funds equal to the demand. This type of equilibrium is called Arrow-Debreu equilibrium, which is defined as there is a set of prices (in this case interest rates) under which demand and supply of the market are equal to each other. Moreover, we can analyze the firm's investment decision and its owner's consumption/saving decision separately (Fisher separation theorem). In addition to that, even in case of bankruptcy risk, the resulting optimum choice of firm will be efficient as the interest rate increases to capture the bankruptcy risk. Therefore, the possibility of default of the borrower is not a main driving force that leads to imperfect capital markets. Asymmetric information The main feature of financial markets that leads to imperfection is information asymmetry between borrowers and lenders. We see two main types of information asymmetries in capital markets: Adverse selection: Adverse selection occurs before the signing of the contract. The lack of information occurs since the lenders do not have information about the type of borrowers, i.e. whether the borrower tends to engage in riskier projects or not. There is positive correlation between possibility of selecting "bad" types as the interest rate increases since it is more costly for safe borrowers than risky borrowers since the possibility of not paying back his/her debt for the risky one is relatively higher. In adverse selection, the borrower type is only known by the individual and occurs when there are not enough tools to screen the borrower types. One of the examples