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Trading dynamics with adverse selection and search: Market freeze, intervention and recovery

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  • Chiu, Jonathan
  • Koeppl, Thorsten V

Abstract

We study trading dynamics in an asset market where the quality of assets is private information and finding a counterparty takes time. When trading ceases in equilibrium as a response to an adverse shock to asset quality, a government can resurrect trading by buying up lemons which involves a financial loss. The optimal policy is centred around an announcement effect where trading starts already before the intervention for two reasons. First, delaying the intervention allows selling pressure to build up thereby improving the average quality of assets for sale. Second, intervening at a higher price increases the return from buying an asset of unknown quality. It is optimal to intervene immediately at the lowest price when the market is sufficiently important. For less important markets, when the shock to quality and search frictions are small, it is optimal to rely on the announcement effect. Here delaying the intervention and fostering the effect by intervening at the highest price tend to be complements.

Suggested Citation

  • Chiu, Jonathan & Koeppl, Thorsten V, 2016. "Trading dynamics with adverse selection and search: Market freeze, intervention and recovery," Working Paper Series 19475, Victoria University of Wellington, School of Economics and Finance.
    • Handle: RePEc:vuw:vuwecf:19475
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    File URL: https://ir.wgtn.ac.nz/handle/123456789/19475
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    Citations

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    Cited by:

    1. Toni Ahnert & Martin Kuncl, 2019. "Loan Insurance, Market Liquidity, and Lending Standards," Staff Working Papers 19-47, Bank of Canada.
    2. Chao Gu & Guido Menzio & Randall Wright & Yu Zhu, 2024. "Market Freezes," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(6), pages 1291-1320, September.
    3. Madison, Florian, 2024. "Asymmetric information in frictional markets for liquidity: Collateralized credit vs asset sale," Journal of Economic Dynamics and Control, Elsevier, vol. 159(C).
    4. Asano, Koji, 2024. "Liquidity policies with opacity," The Quarterly Review of Economics and Finance, Elsevier, vol. 97(C).
    5. Emre Ozdenoren & Kathy Yuan & Shengxing Zhang, 2023. "Dynamic Asset-Backed Security Design," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(6), pages 3282-3314.
    6. Fenghua Song & Anjan V. Thakor, 2023. "Market Freeze and Bank Capital Structure Heterogeneity," Management Science, INFORMS, vol. 69(3), pages 1856-1876, March.
    7. Lester, Benjamin & Shourideh, Ali & Venkateswaran, Venky & Zetlin-Jones, Ariel, 2023. "Market-making with search and information frictions," Journal of Economic Theory, Elsevier, vol. 212(C).
    8. Mäkinen, Taneli & Palazzo, Francesco, 2024. "Adverse selection and search congestion in over-the-counter markets," Journal of Monetary Economics, Elsevier, vol. 146(C).
    9. Changhyun Lee, 2024. "The outside option channel of central bank asset purchase programs: A tale of two crises," Working Papers 363, University of California, Davis, Department of Economics.
    10. Xuewen Liu, 2023. "A Model of Systemic Bank Runs," Journal of Finance, American Finance Association, vol. 78(2), pages 731-793, April.

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