Dynamic Self-Fulfilling Fire Sales

Abstract

Why do fire sales occur if many risks are hedgeable? We study a version of Brunnermeier and Sannikov (2014,American Economic Review104, 379–421) in which all fundamental risks can be hedged frictionlessly. Our analysis shows that fire sales are inherently self-fulfilling. Fundamental shocks can never cause fire sales, and an efficient, safe equilibrium exists. On the other hand, there exists an equilibrium in which agents coordinate fire sales on nonfundamental shocks. A simple refinement based on vanishingly small perceived fundamental risk eliminates the safe equilibrium and selects the fire-sale equilibrium as the unique outcome.