Fire Sales and Contagion in Financial Assets
54 Pages Posted: 13 Dec 2014
Date Written: December 12, 2014
I present a model of fire sales incorporating multiple investors with overlapping asset holdings and heterogeneous leverage constraints. Negative price shocks force asset sales which in turn depress prices, triggering additional forced selling and price declines in a self-reinforcing negative spiral. It is shown that model equilibrium fire sale prices exist, are unique and can be calculated numerically using successive approximations. Model fire sale prices predict the cross-section of US stock returns during times of distress (when the S&P 500 index declines by 10% or more in a calendar quarter). In the 11 distress quarters since 1985 the value-weighted quintile hedge portfolio formed on the prior quarter model fire sale return yielded an average return of 189 basis points per month (t-statistic 3.88). This suggests that the pattern of asset holdings and investor leverage may be important drivers of price dynamics in times of market distress.
Keywords: Fire sales, equilibrium, asset pricing, return predictability, contagion, game theory
JEL Classification: C70, D53, D62, G11, G12, G18
Suggested Citation: Suggested Citation