Public Attention, Adverse Selection, and the Pricing of Stocks

Abstract

We hypothesize that the degree of public attention influences the price level of stocks in a systematic way. We employ a simple discounted cash flow model with adverse selection and fixed transaction costs that determine an endogenous bid-ask-spread. In the model, rational and risk neutral investors incorporate future trading conditions into their price setting behavior. These trading conditions are driven by the degree of public attention and entail an attention-dependent impact of the bid-ask-spread on required gross returns. Specifically, given a high level of public attention a higher bid-ask-spread may negatively affect required asset returns. We argue that the model implications are consistent with empirical findings, i.e. size, book-to-market, and the momentum effect.

Keywords: adverse selection, public attention, liquidity, bid-ask-spread, asset pricing

JEL Classification: G12