Information Asymmetries, Transaction Costs, and the Pricing of Securities

Abstract

I study a simple market microstructure model in a competitive setting where rational risk neutral investors anticipate becoming liquidity sellers at some future date. That is, being forced to sell with a certain probability. The IPO price must compensate buyers for expected transaction costs due to adverse selection. The insights of the model are as follows. First, investors' distribution of liquidity selling needs affects adverse selection cost and hence the IPO price. Second, the marginal investor receives, in equilibrium, an excess return that covers his expected transaction costs. Third, anticipated dissemination of information to the public, just before secondary market trading takes place, lowers uniformly the adverse selection costs. Fourth, the model helps to explain the observed return differences for growth and value stocks in terms of transaction costs. Fifth, the IPO price depends on the issuer's specific allocation of stocks to investors with different liquidity selling needs.

Keywords: adverse selection cost, liquidity trading, transaction cost, IPO, growth stocks, value stocks, cross-section of expected returns

JEL Classification: G12, G14