Contagious Adverse Selection
29 Pages Posted: 22 Dec 2010
Date Written: November 30, 2010
We illustrate the corrosive effect of even small amounts of adverse selection in an asset market and how it can lead to the total breakdown of trade. The problem is the failure of 'market confidence' defined as approximate common knowledge of an upper bound on expected losses. Small probability events can unravel market confidence. We discuss the role of contagious adverse selection and the problem of 'toxic assets' in the recent financial crisis.
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