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Contagious Adverse Selection

29 Pages Posted: 22 Dec 2010  

Stephen Morris

Princeton University - Department of Economics

Hyun Song Shin

Bank for International Settlements

Date Written: November 30, 2010

Abstract

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.

Suggested Citation

Morris, Stephen and Shin, Hyun Song, Contagious Adverse Selection (November 30, 2010). Economic Theory Center Working Paper No. 001-2010. Available at SSRN: https://ssrn.com/abstract=1729236 or http://dx.doi.org/10.2139/ssrn.1729236

Stephen Edward Morris (Contact Author)

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

Hyun Song Shin

Bank for International Settlements ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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