Running for the Exit: Distressed Selling and Endogenous Correlation in Financial Markets

29 Pages Posted: 23 Jan 2011 Last revised: 29 May 2013

See all articles by Rama Cont

Rama Cont

University of Oxford; CNRS

Lakshithe Wagalath

IESEG School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2011

Abstract

We propose a simple multi-period model of price impact in a market with multiple assets, which illustrates how feedback effects due to distressed selling and short selling lead to endogenous correlations between asset classes. We show that distressed selling by investors exiting a fund and short selling of the fund's positions by traders may have non-negligible impact on the realized correlations between returns of assets held by the fund.

These feedback effects may lead to positive realized correlations between fundamentally uncorrelated assets, as well as an increase in correlations across all asset classes and in the fund's volatility which is exacerbated in scenarios in which the fund undergoes large losses. By studying the diffusion limit of our discrete time model, we obtain analytical expressions for the realized covariance and show that the realized covariance may be decomposed as the sum of a fundamental covariance and a liquidity-dependent 'excess' covariance. Finally, we examine the impact of these feedback effects on the volatility of other funds. Our results provide insight into the nature of spikes in correlation associated with the failure or liquidation of large funds.

Keywords: fire sales, distressed selling, liquidity, diffusion models, market impact, price impact, correlation, volatility

Suggested Citation

Cont, Rama and Wagalath, Lakshithe, Running for the Exit: Distressed Selling and Endogenous Correlation in Financial Markets (January 1, 2011). Available at SSRN: https://ssrn.com/abstract=1722508 or http://dx.doi.org/10.2139/ssrn.1722508

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

CNRS ( email )

LPSM
Sorbonne University
Paris
France

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

Lakshithe Wagalath

IESEG School of Management ( email )

1 Parvis de la Défense
Paris, 92044
France

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