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The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity

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  • JAMES DOW
  • JUNGSUK HAN

Abstract

How can fire sales for financial assets happen when the economy contains well†capitalized but nonspecialist investors? Our explanation combines rational expectations equilibrium and “lemons†models. When specialist (informed) market participants are liquidity†constrained, prices become less informative. This creates an adverse selection problem, decreasing the supply of high†quality assets, and lowering valuations by nonspecialist (uninformed) investors, who become unwilling to supply capital to support the price. In normal times, arbitrage capital can “multiply†itself by making uninformed capital function as informed capital, but in a crisis, this stabilizing mechanism fails.

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  • James Dow & Jungsuk Han, 2018. "The Paradox of Financial Fire Sales: The Role of Arbitrage Capital in Determining Liquidity," Journal of Finance, American Finance Association, vol. 73(1), pages 229-274, February.
    • Handle: RePEc:bla:jfinan:v:73:y:2018:i:1:p:229-274
    DOI: 10.1111/jofi.12584
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    Cited by:

    1. Dow, James & Han, Jungsuk & Sangiorgi, Francesco, 2024. "The short-termism trap: Catering to informed investors with limited horizons," Journal of Financial Economics, Elsevier, vol. 159(C).
    2. Mr. Ehsan Ebrahimy, 2019. "Fire Sales in Frozen Markets," IMF Working Papers 2019/092, International Monetary Fund.
    3. Fenghua Song & Anjan V. Thakor, 2023. "Market Freeze and Bank Capital Structure Heterogeneity," Management Science, INFORMS, vol. 69(3), pages 1856-1876, March.
    4. Suzuki, Shiba, 2018. "Inequality and asset fire sales," MPRA Paper 90906, University Library of Munich, Germany.
    5. Farshid Abdi, 2018. "Cycles of Declines and Reversals Following Overnight Market Declines," Working Papers on Finance 1829, University of St. Gallen, School of Finance.
    6. Akihiko Ikeda & Hiroshi Osano, 2020. "Information Investment Regulation and Portfolio Delegation," KIER Working Papers 1032, Kyoto University, Institute of Economic Research.
    7. Ebrahimy, Ehsan, 2019. "Fire-sales in frozen markets," ESRB Working Paper Series 100, European Systemic Risk Board.
    8. Ma, Rui & Anderson, Hamish D. & Marshall, Ben R., 2018. "Market volatility, liquidity shocks, and stock returns: Worldwide evidence," Pacific-Basin Finance Journal, Elsevier, vol. 49(C), pages 164-199.

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