Dynamic Adverse Selection:A Theory of Illiquidity, Fire Sales, and Flight to Quality

Abstract

We develop a theory of equilibrium in asset markets with adverse selection. Traders can buy and sell an asset at any price. Sellers recognize that their trades may be rationed if they ask for a high price, while buyers recognize that they can only get a high quality good by paying a high price. These beliefs are consistent with rational behavior by all traders. In the resulting equilibrium, the existence of low-quality assets reduces the liquidity and price-dividend ratio in the market for high quality assets. The emergence or worsening of an adverse selection causes a fire sale, with the price and liquidity of all such assets declining. The price of other assets that do not suffer from adverse selection may rise, a flight to quality. If a large player purchases and destroys all the low quality assets, the liquidity and price-dividend ratio will increase for high quality assets.