Asset fire sales in an incomplete market economy

This paper studies asset fire sales as an endogenous outcome of competitive general equilibrium. We introduce the “limited arbitrage” asset pricing mechanism into a pure exchange general equilibrium economy. The limited arbitrage framework emphasizes the role of financial intermediaries in conducting fire sales. In our model, financial markets are incomplete, and households face uninsured idiosyncratic endowment risks. Given such market incompleteness, financial intermediaries can gain arbitrage profits by issuing risk-free debt and investing in risky assets. However, the margin requirement ratio limits the amount of debt. Shocks to intermediaries’ balance sheets force them to repay debt and sell shares, causing stock prices to deviate from fundamental levels. We investigate how the risk of a fire sale affects the desirable financial regulation. Lowering the margin requirement ratio has the following trade-offs for welfare. On the one hand, it exaggerates a decline in stock prices due to fire sales, which deteriorates welfare, ex-post. On the other hand, it improves welfare ex-ante by providing households with sufficient self-insurance measures against their idiosyncratic endowment risks. Our numerical examples show that a natural debt limit under a laissez-faire economy is undesirable. Governments can improve welfare by introducing financial regulations (raising the margin requirement ratio).