| By: |
Jonathan Chiu (Bank of Canada);
Thorsten Koeppl (Queen's University) |
| Abstract: |
We study the trading dynamics in an asset market where the quality of assets
is private information of the owner and finding a counterparty takes time.
When trading of a financial asset ceases in equilibrium as a response to an
adverse shock to asset quality, a large player can resurrect the market by
purchasing bad assets which involves financial losses. The equilibrium
response to such a policy is intricate as it creates an announcement effect: a
mere announcement of intervening at a later point in time can cause markets to
function again. This effect leads to a gradual recovery in trading volume,
with asset prices converging non-monotonically to their normal values. The
optimal policy is to intervene immediately at a minimal scale when markets are
deemed important and losses are small. As losses increase and the importance
of the market declines, the optimal intervention is delayed and it can be
desirable to rely more on the announcement effect by increasing the size of
the intervention. Search frictions are important for all these results. They
compound adverse selection, making a market more fragile with respect to a
classic lemons problem. They dampen the announcement effect and cause the
optimal policy to be more aggressive, leading to an earlier intervention at a
larger scale. |
| Keywords: |
Trading Dynamics, Adverse Selection, Search, Intervention in Asset Markets, Announcement Effect |
| JEL: |
G1 E6 |
| Date: |
2011–04 |
| URL: |
http://d.repec.org/n?u=RePEc:qed:wpaper:1267&r=cta |