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

Abstract

How can fire sales for financial assets happen when the economy contains wellcapitalized 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. IN A FIRE SALE, SELLERS ARE FORCED TO SELL assets at deep discounts because no one is willing to buy them at fair prices. Sellers can be forced to sell because of financial distress, credit market frictions, regulation, margin calls, etc. 1 Why do fire sales happen? What makes investors avoid buying assets that are apparently cheap? One explanation is offered by Shleifer and Vishny (1992): if industry experts with higher private valuations do not have enough liquidity, assets are bought at a discount by nonexperts who cannot use them efficiently. This argument applies naturally to real assets rather than financial securities. But since financial securities typically require that the holder only collects cash flows, not operates the assets, there should not be significant differences in private valuations. 2

Cycles of Declines and Reversals following Overnight Market Declines

“…Fourth, by analyzing the order flows following overnight declines, I show that investors on average are contrarian and provide liquidity after market declines, consistent with findings of Chordia, Roll, and Subrahmanyam (2001) for the daily horizon. The price declines on the same day that average investors are contrarian, is in line with Dow and Han (2018), who argue that, although overall capital might not be scarce in the financial market, capital of informed traders can be scarce, and when informed traders face constrains, the rest of the market can provide liquidity to buy assets, but with a "lemon" discount (Akerlof, 1970).…”

“…[ Table V about here] That liquidity further deteriorates for the more volatile stocks, even after controlling for lagged liquidity, can be explained by the recent theoretical development around fire sales puzzles. Dow and Han (2018) argue that while total capital in financial market is not scarce, the capital of the betterinformed investors on a particular asset might be limited. Consequently, when a wealth shock hits liquidity-constrained investors and makes them sell some of their holdings, other less-informed traders in the market are willing to buy those assets only with a "lemon" discount.…”

“…This paper studies declines and reversals between intraday and overnight returns and the way overnight wealth shocks contribute to declines and reversals, and to market liquidity. It also builds on the Adrian and Shin (2010) mark-to-market leverage, and on Dow and Han's (2018) argumentation about the adverse selection discount from uninformed traders' liquidity provision following informed traders' tightened liquidity constraints. Third, and finally, this paper contributes to the existing literature on idiosyncratic volatility by showing that it can explain the cross section of intraday and overnight returns following market declines.…”

Inefficient Fire-Sales in Decentralized Asset Markets

“…Increasing information frictions can be one reason why outside investors did not buy distressed assets during the crisis. Dow and Han (2018) build a model to show how asymmetric information problems may have increased during the crisis leading to low demand by less liquidity constrained investors and hence depressed asset prices. In their model when specialized investors become liquidity constrained, market price becomes less informative about the fundamentals of the asset.…”

“…Adverse selection can be another reason why many buyers did not step in. Dow and Han (2018) show how asymmetric information may have increased during the crisis as specialized investors were capital constrained and hence prices became less informative. current and future dates which are increasing in magnitude over time and a medium degree of imbalance between potential supply and demand for the asset as well as a medium degree of market liquidity.…”