Informational Feedback Effect, Adverse Selection, and the Optimal Disclosure Policy ∗

Abstract

Trading in a secondary stock market not only redistributes wealth among investors but also generates information that guides subsequent investment. We provide a positive theory of disclosure that reflects both functions of the secondary stock market. On one hand, disclosure improves firm value by ameliorating adverse selection among investors. On the other hand, disclosure reduces the private incentive to produce information and thus impedes investment effi ciency. This trade-off determines the optimal disclosure policy. Our theory reconciles the disclosure practice with other prominent features of securities regulation and generates new testable predictions. This paper has benefited from feedbacks we have received on a companion paper of ours titled as “Learn from and disclose to the stock market " presented at Pennsylvania State University, University o