Imperfect Competition, Information Heterogeneity, and Financial Contagion
The Stephen M. Ross School of Business at the University of Michigan
January 13, 2003
Stern School of Business Working Paper
Financial contagion is the propagation of a shock to one security across other fundamentally unrelated securities. In this paper, we examine how heterogeneity of insiders' information about fundamentals may induce excess comovement among asset prices, i.e., beyond the extent justified by the structure of the economy. We develop a model of multi-asset trading, populated by a number of informed strategic speculators facing a trade-off between the maximization of short- versus long-term utility of their wealth, uninformed market-makers, and liquidity traders, in which the liquidation values of the available securities depend on idiosyncratic as well as systematic sources of risk. We show that, even in a setting where such insiders are rational, risk-neutral, and financially unconstrained, financial contagion can be an equilibrium outcome of a semi-strong efficient market, if and only if they receive heterogeneous information about those sources of risk and strategically trade on it. Rational market-makers use the observed aggregate order flow to update their beliefs about the random terminal payoffs of the assets. Imperfectly competitive speculators engage in portfolio rebalancing activity to mask their information advantage. Asymmetric sharing of information among insiders prevents the market-makers from learning about their individual signals and trades with sufficient accuracy. Incorrect cross-inference about fundamentals and contagion then ensue. When used to analyze the transmission of shocks across countries, our model suggests that more adequate regulation of the process of generation and disclosure of information in emerging markets may reduce their vulnerability to international financial contagion.
Number of Pages in PDF File: 58
Keywords: Contagion, Strategic Trading, Information Heterogeneity
JEL Classification: D82, G14, G15
Date posted: April 23, 2003
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