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RFS Advance Access originally published online on August 11, 2003
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Rev Fin 2004; 17:643-665
The Review of Financial Studies Vol. 17, No. 3 © 2004 The Society for Financial Studies; all rights reserved.

Adverse Selection and the Required Return

Nicolae Gârleanu
University of Pennsylvania

Lasse Heje Pedersen
New York University

Address correspondence to Lasse H. Pedersen, Stern School of Business, New York University, 44 West Fourth St. Suite 9-190, New York, NY 10012-1126, or e-mail: lpederse{at}stern.nyu.edu.

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.


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