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

69 Pages Posted: 20 Aug 2013 Last revised: 9 Oct 2015

Nicolae Garleanu

University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Stavros Panageas

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Jianfeng Yu

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 1, 2014

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

Suggested Citation

Garleanu, Nicolae and Panageas, Stavros and Yu, Jianfeng, Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion (June 1, 2014). Chicago Booth Research Paper No. 15-29; Fama-Miller Working Paper . Available at SSRN: https://ssrn.com/abstract=2313026 or http://dx.doi.org/10.2139/ssrn.2313026

Nicolae Bogdan Garleanu

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

HOME PAGE: http://faculty.haas.berkeley.edu/garleanu

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Stavros Panageas (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jianfeng Yu

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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