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Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality

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  • Veronica Guerrieri
  • Robert Shimer

Abstract

We develop a dynamic equilibrium model of asset markets affected by adverse selection. There exists a unique equilibrium where better assets trade at higher prices but in less liquid markets. Sellers of high-quality assets can separate because they are more willing to accept a lower trading probability. As a result, the emergence of adverse selection generates a drop in liquidity. It may also lead to a decline in the price-dividend ratio—a fire sale—and a flight to quality. Subsidies to purchasing assets may be Pareto improving and can reverse the fire sale and flight to quality.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17876.

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Date of creation: Mar 2012
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Publication status: published as “Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality,” with Robert Shimer, AER, forthcoming
Handle: RePEc:nbr:nberwo:17876

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  1. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
  2. Thorsten V. Koeppl & Jonathan Chiu, 2010. "Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort," 2010 Meeting Papers 78, Society for Economic Dynamics.
  3. Andrea L. Eisfeldt, 2004. "Endogenous Liquidity in Asset Markets," Journal of Finance, American Finance Association, vol. 59(1), pages 1-30, 02.
  4. Ben Lester & Braz Camargo, 2010. "Trading Dynamics in Decentralized Markets with Adverse Selection," 2010 Meeting Papers 488, Society for Economic Dynamics.
  5. Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2011 Meeting Papers 157, Society for Economic Dynamics.
  6. V.V. Chari & Ali Shourideh & Ariel Zetlin-Jones, 2010. "Adverse Selection, Reputation and Sudden Collapses in Secondary Loan Markets," NBER Working Papers 16080, National Bureau of Economic Research, Inc.
  7. Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," Discussion Papers 1513, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
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Cited by:
  1. Wei Cui & Sören Radde, 2014. "Search-Based Endogenous Illiquidity and the Macroeconomy," Discussion Papers of DIW Berlin 1367, DIW Berlin, German Institute for Economic Research.
  2. Robert Shimer & Veronica Guerrieri, 2013. "Markets with Multidimensional Private Information," 2013 Meeting Papers 210, Society for Economic Dynamics.
  3. Yiting Li & Guillaume Rocheteau & Pierre-Olivier Weill, 2011. "Liquidity and the Threat of Fraudulent Assets," NBER Working Papers 17500, National Bureau of Economic Research, Inc.

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