Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality
AbstractWe develop a dynamic equilibrium model of asset markets with adverse selection. There exists a unique equilibrium in which better quality assets trade at higher prices but with a lower price-dividend ratio in less liquid markets. Sellers of high-quality assets signal quality by accepting a lower trading probability. We show how the distribution of sellers' private information affects an asset's price and liquidity, how a change in that distribution can cause a fire sale and a flight to quality, and how asset purchase and subsidy programs may raise prices and liquidity and reverse the flight to quality.
CitationGuerrieri, Veronica, and Robert Shimer. 2014. "Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality." American Economic Review, 104 (7): 1875-1908. DOI: 10.1257/aer.104.7.1875
- D82 Asymmetric and Private Information; Mechanism Design
- G12 Asset Pricing; Trading Volume; Bond Interest Rates