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

62 Pages Posted: 30 Aug 2013

See all articles by Nicolae Garleanu

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: August 2013

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. Despite the ex-ante symmetry of investors, their strategies may (endogenously) exhibit diversity, with some investors in each location following high-leverage, high-participation, and high-cost strategies and some unleveraged, low-participation, and low-cost strategies. The capital allocated to high-leverage strategies may be vulnerable even to small changes in market-access costs, which can lead to discontinuous price drops, de-leveraging, and portfolio-flow reversals. Moreover, the market is subject to contagion, in that an adverse shock to investors at a subset of locations affects prices everywhere.

Suggested Citation

Garleanu, Nicolae Bogdan and Panageas, Stavros and Yu, Jianfeng, Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion (August 2013). NBER Working Paper No. w19381. Available at SSRN: https://ssrn.com/abstract=2318283

Nicolae Bogdan Garleanu (Contact Author)

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

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

National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Stavros Panageas

University of Chicago - Booth School of Business ( email )

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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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