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

The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity How can fire sales for financial assets happen when the economy contains well‐capitalized but nonspecialist 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 nonspecialist (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. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

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

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Publisher
Wiley
Copyright
© 2018 the American Finance Association
ISSN
0022-1082
eISSN
1540-6261
D.O.I.
10.1111/jofi.12584
Publisher site
See Article on Publisher Site

Abstract

How can fire sales for financial assets happen when the economy contains well‐capitalized but nonspecialist 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 nonspecialist (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.

Journal

The Journal of FinanceWiley

Published: Jan 1, 2018

References

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