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Information Acquisition and Secondary Market Liquidity

We develop a credit-risk model to study how information acquisition affects the liquidity in a secondary bond market. In our model, the creditors of a firm can acquire costly information about the firm and exploit the information advantage by selling their bonds to uninformed buyers. When a firm's fundamental deteriorates, creditors have higher incentives to acquire information, resulting in a higher degree of adverse selection in the secondary market. Consistent with empirical evidence, our model predicts that the trading volume and the transaction costs of bonds are both increasing in the credit risks of the underlying firms.