Adverse Selection and Re-Trade

Nicolae Bogdan Garleanu, Lasse Heje Pedersen
2002 Social Science Research Network  
An important feature of financial markets is that securities are traded repeatedly by asymmetrically informed investors. We study how current and future adverse selection affect the required return. We find that the bid-ask spread generated by adverse selection is not a cost, on average, for agents who trade, and hence the bid-ask spread does not directly influence the required return. Adverse selection contributes to trading-decision distortions, however, implying allocation costs, which
more » ... the required return. We explicitly derive the effect of adverse selection on required returns, and show how our result differs from models that consider the bid-ask spread to be an exogenous cost. * We thank
doi:10.2139/ssrn.302025 fatcat:zdutd23nibesniy23eqp3mc2he