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

  • Veronica Guerrieri
  • Robert Shimer

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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File URL: http://www.nber.org/papers/w17876.pdf
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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 Veronica Guerrieri & Robert Shimer, 2014. "Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality," American Economic Review, American Economic Association, vol. 104(7), pages 1875-1908, July.
Handle: RePEc:nbr:nberwo:17876
Note: AP EFG
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  1. Guillaume Rocheteau & Ricardo Lagos, 2008. "Liquidity in asset markets with search frictions," Working Paper 0804, Federal Reserve Bank of Cleveland.
  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. 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.
  4. 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.
  5. Camargo, Braz & Lester, Benjamin, 2014. "Trading dynamics in decentralized markets with adverse selection," Journal of Economic Theory, Elsevier, vol. 153(C), pages 534-568.
  6. Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2011 Meeting Papers 157, Society for Economic Dynamics.
  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. Veronica Guerrieri & Robert Shimer & Randall Wright, 2009. "Adverse Selection in Competitive Search Equilibrium," NBER Working Papers 14915, National Bureau of Economic Research, Inc.
  9. Andrea L. Eisfeldt, 2004. "Endogenous Liquidity in Asset Markets," Journal of Finance, American Finance Association, vol. 59(1), pages 1-30, 02.
  10. 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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