Asset Pricing in Network Economies with Systemic Risk
65 Pages Posted: 21 Nov 2017 Last revised: 20 Apr 2018
Date Written: November 19, 2017
This paper studies inter-temporal asset pricing in network economies when distress shocks propagate over time. We show the existence of two classes of equilibria. In the first, firm specific shocks are diversifiable and standard Lucas valuation formulas apply. In the second, shocks propagate becoming endemic and non-diversifiable, so that the cross-section of expected returns depends on rm exposure to systemic risks in ways that depend on network topology. As an application, we discuss asset pricing in a dynamic extension of the interbank network of Acemoglu, Ozdaglar and Tahbaz-Salehi (2015). For large debt levels the equilibrium becomes supercritical. Cascades of shocks induce an interbank spread over the risk free rate, increase the cost of equity capital of interconnected financial institutions and rationalize the empirically documented bank sector size premium. Finally, we discuss how financial sector concentration affects the trade-off between network stability and resilience.
Keywords: Network, asset pricing, systemic risk, contagion, cascades
JEL Classification: D9, E3, E4, G12
Suggested Citation: Suggested Citation