Adverse selection

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1.

Project appraisal.

The problems of accepting projects which should be rejected, or rejecting ones which should be accepted.


One cause of adverse selection is using the wrong cost of capital for making the evaluation.

For example using a cost of capital which is either too low or too high, because of failing to take appropriate account of the relevant risk of the project under review. This can happen when a firm's existing average cost of capital is used to evaluate new projects whose risk differs from the average risk of the firm's existing business.


2.

Any market situation in which there is asymmetry of information between the participants, potentially leading to the market being illiquid because fewer participants are willing to trade.


Adverse selection is not to be confused with anti-selection, which is different.


See also