Dynamic Adverse Selection: Time-Varying Market Conditions and Endogenous Entry

39 Pages Posted: 30 Aug 2015

See all articles by Pavel Zryumov

Pavel Zryumov

University of Rochester - Simon Business School

Date Written: May 9, 2015

Abstract

In this paper I analyze the effects of time-varying market conditions and endogenous entry on the equilibrium dynamics of markets plagued by adverse selection. I show that variation in gains from trade, stemming from market conditions, creates an option value and distorts liquidity when gains from trade are low. An improvement in market conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications: early stage financing, initial public offerings, and private equity buyouts.

Suggested Citation

Zryumov, Pavel, Dynamic Adverse Selection: Time-Varying Market Conditions and Endogenous Entry (May 9, 2015). Available at SSRN: https://ssrn.com/abstract=2653129 or http://dx.doi.org/10.2139/ssrn.2653129

Pavel Zryumov (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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