Adverse Selection and Risk Aversion in Capital Markets

Abstract

We generalize the Boadway and Keen (2006) model of adverse selection in a capital market to allow for risk aversion on the part of entrepreneurs. We show that the Boadway and Keen conclusion-that adverse selection leads to excessive investment-does not necessarily hold when entrepreneurs are risk averse. We use their framework, with the additional assumption of risk aversion, to analyze the effect of policies that would reduce entrepreneurs' reliance on debt or equity financing by outside investors. We show that such policies, by exposing entrepreneurs to more down-side risk, may reduce the level of investment in risky projects, increase inequality and potentially reduce social welfare.adverse selection; capital markets; inefficiency; risk and entrepreneurship