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Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

  • Jonathan Chiu

    (Bank of Canada)

  • Thorsten Koeppl

    ()

    (Queen's University)

We study the trading dynamics in an asset market where the quality of assets is private information of the owner and finding a counterparty takes time. When trading of a financial asset ceases in equilibrium as a response to an adverse shock to asset quality, a large player can resurrect the market by purchasing bad assets which involves financial losses. The equilibrium response to such a policy is intricate as it creates an announcement effect: a mere announcement of intervening at a later point in time can cause markets to function again. This effect leads to a gradual recovery in trading volume, with asset prices converging non-monotonically to their normal values. The optimal policy is to intervene immediately at a minimal scale when markets are deemed important and losses are small. As losses increase and the importance of the market declines, the optimal intervention is delayed and it can be desirable to rely more on the announcement effect by increasing the size of the intervention. Search frictions are important for all these results. They compound adverse selection, making a market more fragile with respect to a classic lemons problem. They dampen the announcement effect and cause the optimal policy to be more aggressive, leading to an earlier intervention at a larger scale.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1267.pdf
File Function: First version 2011
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Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1267.

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Length: 61 pages
Date of creation: Apr 2011
Date of revision:
Handle: RePEc:qed:wpaper:1267
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