We illustrate the corrosive effect of even small amounts of adverse selection in an asset market and show how it can lead to the total breakdown of trade. The problem is the failure of "market confidence," defined as approximate common knowledge of an upper bound on expected losses. Small probability events can unravel market confidence. We discuss the role of contagious adverse selection
and the problem of "toxic assets" in the recent financial crisis. (JEL D82, G01, G12, G14)
"Contagious Adverse Selection."
American Economic Journal: Macroeconomics,
Asymmetric and Private Information
Asset Pricing; Trading volume; Bond Interest Rates
Information and Market Efficiency; Event Studies