Adverse Selection and Re-Trade

31 Pages Posted: 11 Nov 2008

See all articles by Nicolae Garleanu

Nicolae Garleanu

University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: September 2003

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.

Suggested Citation

Garleanu, Nicolae Bogdan and Pedersen, Lasse Heje, Adverse Selection and Re-Trade (September 2003). NYU Working Paper No. FIN-03-045, Available at SSRN: https://ssrn.com/abstract=1299505

Nicolae Bogdan Garleanu (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

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Copenhagen Business School - Department of Finance ( email )

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New York University (NYU) ( email )

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