Paradox of financial fire sales and the role of arbitrage capital
Subject
Finance
Publishing details
Working Paper
Authors / Editors
Dow J; Jungsuk H
Biographies
Publication Year
2016
Abstract
How can fire sales for financial assets happen when the economy contains well capitalized, but non-specialist investors? Our explanation combines rational expectations equilibrium and "lemons" models. When specialist (informed) market participants are liquidity-constrained, prices become less informative. This creates an adverse selection problem, decreasing the supply of high-quality assets, and lowering valuations by non-specialist (uninformed) investors, who become unwilling to supply capital to support the price. In normal times, arbitrage capital can "multiply" itself by making uninformed capital function as informed capital, but in a crisis this stabilizing mechanism fails.
Keywords
Fire sales; Adverse selection; Market freeze; Illiquidity; Informed trading; Multiplier effect
Series
Working Paper