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Adverse Selection and Liquidity Distortion

Author

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  • Briana Chang
Abstract
This article develops a tractable model with two-dimensional asymmetric information in asset markets: sellers are privately informed about their asset quality and distress positions. Illiquidity arises endogenously and manifests itself through two distinct market outcomes. The first outcome features limited market participation, resulting in a dry-up in trading volume. The second outcome involves a large volume at a depressed price. Only in the latter outcome do distressed sellers engage in fire sales, quickly unwinding their positions at a steep price discount. The article further establishes that this equilibrium can arise only when buyers expect that sellers with a higher need for immediacy will on average have higher-quality assets. Hence, both the information structure and the distribution of sellers’ distress are crucial for the existence of fire sales.

Suggested Citation

  • Briana Chang, 2018. "Adverse Selection and Liquidity Distortion," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(1), pages 275-306.
    • Handle: RePEc:oup:restud:v:85:y:2018:i:1:p:275-306.
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    File URL: http://hdl.handle.net/10.1093/restud/rdx015
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    More about this item

    Keywords

    Liquidity; Fire sales; Market dry-up; Decentralized trading;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G1 - Financial Economics - - General Financial Markets

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