The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity

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