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

Abstract

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.

Keywords: Financial frictions, Market fragmentation, Leverage, Crashes, Contagion

JEL Classification: G01, G12