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Contagion in Debt and Collateral Markets

Jin-Wook Chang

MPRA Paper from University Library of Munich, Germany

Abstract: This paper investigates contagion in financial networks through both debt and collateral markets. Payment from a collateralized debt contract depends not only on the borrower's balance sheet but also on the price of the underlying collateral. I show that the existence of the collateral channel of contagion amplifies the contagion from the counterparty channel, and this additional channel generates different patterns of contagion for a given network structure. If the negative liquidity shock is small, then having more connections make the network safer as contagion through debt channel is minimized by diversified exposures while contagion through collateral channel is limited. However, if the liquidity shock is large, then having more connections make the network more vulnerable as contagions through both debt and collateral channels are maximized by more exposures. The most novel and surprising result is that the ring network is safer than the complete network when the shock is large. This is because the ring network minimizes the contagion through collateral channel while maximizing the contagion through debt channel. The model also provides the minimum collateral-debt ratio (haircut) to attain robust macro-prudential state for a given network structure and aggregate shock.

Keywords: collateral; contagion; debt; financial networks; interconnectedness; systemic risk (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G23 G24 G28 (search for similar items in EconPapers)
Date: 2021-12-12
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-mac and nep-net
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Downloads: (external link)
https://mpra.ub.uni-muenchen.de/111131/1/url_q%3Dh ... ytG6v6ubhEPLNQWGQrCA original version (application/pdf)
https://mpra.ub.uni-muenchen.de/115441/1/url_q%3Dh ... ytG6v6ubhEPLNQWGQrCA revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/115444/2/Contagion ... kets_3_0__Draft_.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/115901/9/MPRA_paper_115901.pdf revised version (application/pdf)

Related works:
Working Paper: Contagion in Debt and Collateral Markets (2023) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:111131

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