Adverse Selection and Re-Trade

Abstract

Many 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 leads to trading-decision distortions, however, implying allocation costs, which affect the required return. We derive explicitly the effect on required returns, and show that our result differs from models that consider the bid-ask spread to be an exogenous cost.