Fire Sales and Contagion in Financial Assets
70 Pages Posted: 5 Dec 2011
Date Written: December 4, 2011
I formulate a general model of fire sales in which multiple heterogeneous investors, each investing in multiple assets, become forced sellers due to exogenous price shocks. Simultaneously prices endogenously adjust based on the volume of forced sales. This induces strategic interaction between investors via price changes. I show that equilibrium fire sale prices exist, are unique and can be calculated to arbitrary accuracy using the method of successive approximations. I derive an analytical price approximation, which is shown (numerically) to explain 98% of the true price adjustment. Analytical statics derived from this approximation allows me to quantify fire sale contagion effects which are, in this model, due entirely to overlapping asset holdings and leverage constraints. Further, I show that changes in leverage by a single investor has spillover effects such that risk externalities are imposed on other investors.
Keywords: Fire Sales, Contagion, Leverage, Game Theory
JEL Classification: G12, C70, G33
Suggested Citation: Suggested Citation