Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

Stavros Panageas, Jianfeng Yu and Nicolae Garleanu
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Jianfeng Yu: University of Minnesota
Nicolae Garleanu: University of California, Berkeley

No 711, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a unied model of limited market integration, asset-price determination, leveraging, and contagion. Investors and firms are located on a circle, and access to markets involves participation costs that increase with distance. Despite the exante symmetry of investors, their strategies may (endogenously) exhibit diversity, with some investors in each location following high-leverage, high-participation, and high-cost strategies and some unleveraged, low-participation, and low-cost strategies. The capital allocated to high-leverage strategies may be vulnerable even to small changes in market-access costs, which can lead to discontinuous price drops, de-leveraging, and portfolio- flow reversals. Moreover, the market is subject to contagion, in that an adverse shock to investors at a subset of locations affects prices everywhere.

Date: 2014
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Related works:
Journal Article: Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion (2015)
Working Paper: Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed014:711

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