ABSTRACT
This chapter begins with a discussion regarding the need for regulation, which generally comes from information asymmetry. It then discusses the applicability of contract theory to IEF as well as a technical aspect concerning uncertainty and information asymmetry in an Islamic context. The chapter also discusses classic solutions to the two main problems associated with information asymmetry, namely adverse selection and moral hazard before demonstrating how a contract theory model works. DeMarzo & Fishman, which uses the contract theory approach to determine the optimality of using debt, equity, and combinations of both. They both also allow the agent to divert funds away from more productive activities. Information asymmetry by itself facilitates strategic actions that benefit one party at the expense of another, which can happen before (adverse selection) or after (moral hazard) the contract is effected.
