Editing Adverse selection (section)

=== Capital markets ===
When raising capital, some types of securities are more prone to adverse selection than others.  An equity offering for a company that reliably generates earnings at a good price will be bought up before an unknown company's offering, leaving the market filled with less desirable offerings that were unwanted by other investors. Assuming that managers have inside information about the firm, outsiders are most prone to adverse selection in equity offers. This is because managers may offer stock when they know the offer price exceeds their private assessments of the company's value. Outside investors, therefore, require a high rate of return on equity to compensate them for the risk of buying a "lemon".

Adverse selection costs are lower for debt offerings. When debt is offered, this acts as a signal to outside investors that the firm's management believes the current stock price is undervalued, as the firm would otherwise be keen on offering equity.

Thus the required returns on debt and equity are related to perceived adverse selection costs, implying that debt should be cheaper than equity as a source of external capital, forming a "[[Pecking order theory|pecking order]]".<ref>{{cite journal|title = Corporate financing and investment decisions when firms have information that investors do not have|doi=10.1016/0304-405X(84)90023-0|volume=13|issue = 2|journal=Journal of Financial Economics|pages=187–221|year = 1984|last1 = Myers|first1 = Stewart C.|last2 = Majluf|first2 = Nicholas S.|hdl = 1721.1/2068|url=http://www.nber.org/papers/w1396.pdf |hdl-access = free}}</ref>

The example described assumes that the market does not know managers are selling stock. The market could gain access to this information, perhaps by finding it in company reports. In this case, the market will capitalize on the information found. If the market has access to the company's information, the presence of information asymmetry is removed, and as such there is no longer a state of adverse selection.

The presence of adverse selection in capital markets results in excessive private investment. Projects that otherwise would not have received investments due to having a lower expected return than the [[opportunity cost]] of capital, received funding as a result of information asymmetry in the market. As such, governments must account for the presence of adverse selection in the implementation of public policies.<ref>{{cite journal |last1=Braido |first1=Luis H. B. |last2=da Costa |first2=Carlos E. |last3=Dahlby |first3=Bev |title=Adverse Selection and Risk Aversion in Capital Markets |journal=FinanzArchiv |date=2011 |volume=67 |issue=4 |pages=303–326 |doi=10.1628/001522111X614141 |jstor=41472630 |url=https://sites.ualberta.ca/~econwps/2009/wp2009-15.pdf }}</ref>