Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion
University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
University of Minnesota
June 1, 2014
Chicago Booth Research Paper No. 15-29
Fama-Miller Working Paper
We propose a unified 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. Due to a complementarity between participation and leverage decisions, the market equilibrium may exhibit diverse leverage and participation choices across investors, even though investors are ex-ante identical. Small changes in market-access costs can cause a change in the type of equilibrium and lead to discontinuous price changes, de-leveraging, and portfolio flow reversals. Moreover, the market is subject to contagion, in that an adverse shock to investors in a subset of locations affects prices everywhere.
Number of Pages in PDF File: 69
Keywords: Financial frictions, Market fragmentation, Leverage, Crashes, Contagion
JEL Classification: G01, G12
Date posted: August 20, 2013 ; Last revised: October 9, 2015
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