Contagion as a Wealth Effect

Abstract

Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined~numerically! as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management.

Market Liquidity and Funding Liquidity

“…Our commonality results can also be related to certain work on contagion (see e.g. Allen and Gale (2000), Kyle and Xiong (2001), and Brunnermeier and Pedersen (2005)). …”

Concentrated Capital Losses and the Pricing of Corporate Credit Risk

“…The importance of capital market frictions is central to theoretical models of limits to arbitrage (Shleifer and Vishny (1997); Kyle and Xiong (2001)), slow moving capital (Duffie (2010); Acharya, Shin, and Yorulmazer (2013); Duffie and Strulovici (2012)), and financial intermediary-based asset pricing (Brunnermeier and Sannikov (2014); He and Krishnamurthy (2013); Adrian and Boyarchenko (2013)). On the empirical side, examples of previous studies on asset pricing with limited investment capital include Froot and O'Connell (2008), Gabaix, Krishnamurthy, and Vigneron (2007), Mitchell, Pedersen, and Pulvino (2007), Coval and Stafford (2007), Chen, Joslin, and Ni (2014b), Acharya, Schaefer, and Zhang (2014), and Adrian, Etula, and Muir (2014).…”

Complex Evolutionary Systems in Behavioral Finance

“…In the rational expectations benchmarks all agents forecast the price to be equal to its fundamentalists and chartists. In the same spirit Kyle and Xiong (2001) introduce a long-term investor that holds a risky asset in an amount proportional to the spread between the asset price and its fundamental value. Since in the experiments the fundamental value is p f = 60, the weight of the fundamentalist traders is bounded above by n = 1 − exp`− 3 10´≈ 0.26.…”