Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality
Veronica Guerrieri, Robert Shimer
American Economic Review · 2014 · Volume 104 · Issue 7
Abstract
We 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.
Keywords
Asymmetric and Private Information, Mechanism Design, Asset Pricing, Trading Volume, Bond Interest Rates
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