Dynamic Unravelling

Abstract

This paper studies price and liquidity dynamics in the presence of costly short-selling when uninformed traders have limited willingness-to-pay to trade securities. In this setting, unravelling and Bayesian social learning interact to produce a novel mechanism, dynamic unravelling: unravelling that generates signals that lead to future unravelling. Applying the theory, I show how dynamic unravelling explains low-volume crashes: falls in the prices of securities on low or declining trading volume. In this context, short-selling restrictions can make low volume crashes more likely by intensifying dynamic unravelling but liquidity injections have the opposite effect.

Keywords: Financial Crashes, Adverse Selection, Asymmetric Information, Short-Selling, Liquidity

JEL Classification: D53, D82, D83, G01, G14