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

Abstract

We develop a dynamic equilibrium model of asset markets affected by adverse selection. There exists a unique equilibrium where better assets trade at higher prices but in less liquid markets. Sellers of high-quality assets can separate because they are more willing to accept a lower trading probability. As a result, the emergence of adverse selection generates a drop in liquidity. It may also lead to a decline in the price-dividend ratio--a fire sale--and a flight to quality. Subsidies to purchasing assets may be Pareto improving and can reverse the fire sale and flight to quality.