Bid-ask spreads, informed investors, and the firm’s financial condition

As the firm’s financial condition worsens, informed trading increases in the firm’s stock and uninformed traders exit the market. Market-makers widen spreads in response to the increased probability of a trade against an informed investor. Using alternative proxies for the firm’s financial condition, we find that financially ailing firms do indeed have higher bid-ask spreads. The results obtain after controlling for key factors known to influence spreads. Our analysis suggests that a deteriorating financial condition can lower shareholder wealth through its effect on bid-ask spreads.