The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity
57 Pages Posted: 16 Mar 2015 Last revised: 3 Aug 2017
Date Written: January 21, 2017
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
JEL Classification: G14, G21, D82, D83, D84
Suggested Citation: Suggested Citation