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

See all articles by James Dow

James Dow

London Business School - Institute of Finance and Accounting

Jungsuk Han

Swedish House of Finance

Date Written: January 21, 2017

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

JEL Classification: G14, G21, D82, D83, D84

Suggested Citation

Dow, James and Han, Jungsuk, The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity (January 21, 2017). Journal of Finance, Forthcoming; Swedish House of Finance Research Paper No. 15-10. Available at SSRN: https://ssrn.com/abstract=2578626 or http://dx.doi.org/10.2139/ssrn.2578626

James Dow

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

Jungsuk Han (Contact Author)

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Register to save articles to
your library

Register

Paper statistics

Downloads
371
Abstract Views
2,388
rank
79,469
PlumX Metrics