The paradox of financial fire sales: the role of arbitrage capital in determining liquidity

Dow, J and Jungsuk, H (2017) The paradox of financial fire sales: the role of arbitrage capital in determining liquidity. The Journal of Finance. ISSN 0022-1082 (In Press)

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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.

Item Type: Article
Additional Information: This is the peer reviewed version of the following article: Dow, J; Han, J (2017). The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity, Journal of Finance which has been published in final form at http://dx.doi.org/10.1111/jofi.12584. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving. © 2017 The American Finance Association
Subjects: S > Speculation
Subject Areas: Finance
DOI: 10.1111/jofi.12584
Date Deposited: 04 Jul 2017 10:22
Last Modified: 06 Oct 2017 15:39
URI: http://lbsresearch.london.edu/id/eprint/826

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