Securities are traded by buyers and sellers with different levels of knowledge about those securities. One party may suspect the other of knowing more about the security than they do, and this could affect the buyer’s bid or the seller’s offering price. This paper seeks to answer two questions: What are the costs implied by present and future asymmetric information? And how are those costs reflected in securities prices?
We find that asymmetric information leads to adverse selection and imperfect risk sharing, resulting in a reduced price and a higher 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, like the cost of trading.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.