Information Asymmetries, Transaction Cost, and the Pricing of Securities

I study a simple market microstructure model in a competitive setting where rational risk neutral investors anticipate becoming liquidity sellers (they are forced to sell with a certain probability) and paying transaction costs (adverse selection costs as well as fixed and/or proportional cost) at some future date. To buy stocks in the IPO they must be compensated for expected future trading losses due to adverse selection risk. The insights of the model are the follows. First, investor’s 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, and, as a consequence, the cost of capital. 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 specific allocation of stocks to investors with different liquidity selling needs.