THE JOURNAL OF FINANCE
VOL. LXXIII, NO. 1
The Paradox of Financial Fire Sales: The Role
of Arbitrage Capital in Determining Liquidity
JAMES DOW and JUNGSUK HAN
How can ﬁre sales for ﬁnancial assets happen when the economy contains well-
capitalized but nonspecialist investors? Our explanation combines rational expec-
tations equilibrium and “lemons” models. When specialist (informed) market par-
ticipants are liquidity-constrained, prices become less informative. This creates an
adverse selection problem, decreasing the supply of high-quality assets, and lowering
valuations by nonspecialist (uninformed) investors, who become unwilling to sup-
ply 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.
N A FIRE SALE
SELLERS ARE FORCED TO SELL
assets at deep discounts because no
one is willing to buy them at fair prices. Sellers can be forced to sell because
of ﬁnancial distress, credit market frictions, regulation, margin calls, etc.
Why do ﬁre sales happen? What makes investors avoid buying assets that are
apparently cheap? One explanation is offered by Shleifer and Vishny (1992): if
industry experts with higher private valuations do not have enough liquidity,
assets are bought at a discount by nonexperts who cannot use them efﬁciently.
This argument applies naturally to real assets rather than ﬁnancial securities.
But since ﬁnancial securities typically require that the holder only collects
cash ﬂows, not operates the assets, there should not be signiﬁcant differences
in private valuations.
James Dow is from London Business School and Jungsuk Han is from Stockholm School of
Economics. We thank three anonymous referees, an Associate Editor, and Bruno Biais (the Editor)
for very helpful comments. We also thank Brandon Daley, Marco Di Maggio, Alex Edmans, Julian
Franks, Simon Gervais, Vincent Glode, John Kuong, Pete Kyle, Paolo Sodini, Per Str
orgen Weibull, as well as seminar participants at AFA 2016, Brevan Howard/FTG conference
2016, Cambridge Corporate Finance Theory Symposium 2015, FIRS 2016, Jackson Hall ﬁnance
conference 2016, BI Norwegian Business School, INSEAD, Korea University, London Business
School, Sungkyunkwan University, Sungkyunkwan GSB, Stockholm School of Economics, Univer-
sity of Gothenburg, University of Mannheim, and Yonsei University. Dow declares that he has not
received any ﬁnancial support for the research described in this paper, and he also has no relevant
or material ﬁnancial interests that relate to the research described in this paper. Han declares
that he has not received any ﬁnancial support for the research described in this paper, and he also
has no relevant or material ﬁnancial interests that relate to the research described in this paper.
See, for example, Shleifer and Vishny (2011)forasurvey.
Some differences in valuation for ﬁnancial securities do exist. For example, some holders are
able to repo the security and others are not. Also, expert investors may understand the risk of