Dynamic Self‐Fulfilling Fire Sales

ABSTRACT Why do fire sales occur if many risks are hedgeable? We study a version of Brunnermeier and Sannikov (2014, American Economic Review 104, 379–421) in which all fundamental risks can be hedged frictionlessly. Our analysis shows that fire sales are inherently self‐fulfilling. Fundamental shocks can never cause fire sales, and an efficient, safe equilibrium exists. On the other hand, there exists an equilibrium in which agents coordinate fire sales on nonfundamental shocks. A simple refinement based on vanishingly small perceived fundamental risk eliminates the safe equilibrium and selects the fire‐sale equilibrium as the unique outcome.