FIN-03-045 |
NYU Stern School of Business |
September 2003
Nicolae Garleanu and Lasse Heje Pedersen
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 in
uence 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.
Nicolae Garleanu
Institution: Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA
19104-6367
Email: garleanu@wharton.upenn.edu
Lasse Heje Pedersen
Institution: Stern School of Business, New York University
Phone: (212) 998-0359
Fax: (212) 995-4233
Email: lpederse@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~lpederse
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