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Adverse Selection and the Required Return

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  • Nicolae Gârleanu

Abstract

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 affect 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. Copyright 2004, Oxford University Press.

Suggested Citation

  • Nicolae Gârleanu, 2004. "Adverse Selection and the Required Return," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 643-665.
  • Handle: RePEc:oup:rfinst:v:17:y:2004:i:3:p:643-665
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    File URL: http://hdl.handle.net/10.1093/rfs/hhg032
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    Cited by:

    1. Ariel Zetlin-Jones & Ali Shourideh, 2010. "Aggregate Fluctuations with Adverse Selection in Credit Markets," 2010 Meeting Papers 376, Society for Economic Dynamics.
    2. Anginer, Deniz, 2010. "Liquidity clienteles : transaction costs and investment decisions of individual investors," Policy Research Working Paper Series 5318, The World Bank.
    3. Banerjee, Snehal & Graveline, Jeremy J., 2014. "Trading in derivatives when the underlying is scarce," Journal of Financial Economics, Elsevier, vol. 111(3), pages 589-608.
    4. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    5. Marinelli, Carlo & Weissensteiner, Alex, 2014. "On the relation between forecast precision and trading profitability of financial analysts," Journal of Financial Markets, Elsevier, vol. 20(C), pages 39-60.
    6. Vayanos, Dimitri & Wang, Jiang, 2009. "Liquidity and asset prices: a united framework," LSE Research Online Documents on Economics 29303, London School of Economics and Political Science, LSE Library.
    7. Turan G. Bali & Lin Peng & Yannan Shen & Yi Tang, 2013. "Liquidity Shocks and Stock Market Reactions," Koç University-TUSIAD Economic Research Forum Working Papers 1304, Koc University-TUSIAD Economic Research Forum.
    8. Kang, Moonsoo, 2010. "Probability of information-based trading and the January effect," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 2985-2994, December.
    9. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    10. Korajczyk, Robert A. & Sadka, Ronnie, 2008. "Pricing the commonality across alternative measures of liquidity," Journal of Financial Economics, Elsevier, vol. 87(1), pages 45-72, January.
    11. James J. Choi & Li Jin & Hongjun Yan, 2013. "Informed Trading and Expected Returns," NBER Working Papers 18680, National Bureau of Economic Research, Inc.
    12. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, Elsevier.
    13. V.V. Chari & Ali Shourideh & Ariel Zetlin-Jones, 2010. "Adverse Selection, Reputation and Sudden Collapses in Secondary Loan Markets," NBER Working Papers 16080, National Bureau of Economic Research, Inc.
    14. Gârleanu, Nicolae, 2009. "Portfolio choice and pricing in illiquid markets," Journal of Economic Theory, Elsevier, vol. 144(2), pages 532-564, March.
    15. Christian Leuz & Catherine Schrand, 2009. "Disclosure and the Cost of Capital: Evidence from Firms' Responses to the Enron Shock," NBER Working Papers 14897, National Bureau of Economic Research, Inc.
    16. Duarte, Jefferson & Young, Lance, 2009. "Why is PIN priced?," Journal of Financial Economics, Elsevier, vol. 91(2), pages 119-138, February.

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