Dynamic Unravelling

Abstract

Rapid declines in the prices of financial securities on low trading volume -- low volume crashes -- are ubiquitous. This paper proposes a dynamic model with informational asymmetries and costly short-selling to explain this phenomenon. Owing to short-selling constraints, no-trade events are bad news. No-trade therefore lowers prices, worsens adverse selection, increases bid-ask spreads and causes liquidity traders to leave the market, making no-trade more likely. This generates endogenous auto-correlation in no-trade events -- dynamic unravelling -- and causes low volume crashes. Short-selling prohibitions harm price discovery and make crashes more likely. Liquidity interventions aid price discovery and avert crashes.