Asset Pricing Implications of Systemic Risk in Network Economies
70 Pages Posted: 21 Nov 2017 Last revised: 16 Jul 2019
Date Written: November 19, 2017
This paper studies inter-temporal asset pricing in network economies when distress shocks can propagate. Two classes of equilibria exists. In the first, firm specific shocks are diversifiable and standard Lucas valuation formulas apply. In the second, shocks propagate and form cascades becoming endemic and non-diversifiable. We study a dynamic extension of the interbank network of Acemoglu, Ozdaglar and Tahbaz-Salehi (2015) and characterize the link between network topology and (i) stability, (ii) economic resilience, (iii) crisis duration. Financial sector concentration affects the trade-offs between network stability and resilience, and between probability and duration of a crisis. Large debt levels can trigger cascades of shocks, inducing larger interbank (Libor) spreads and cost of equity capital of peripheral nancial institutions. We derive closed-form solutions for equilibrium asset prices. Cascades induce a violation of the CAPM: idiosyncratic shocks affect expected excess returns, the cross-section of risk premia depends on rm exposure to network cascade risk and its distribution is negatively skewed.
Keywords: Network, asset pricing, systemic risk, contagion, cascades
JEL Classification: D9, E3, E4, G12
Suggested Citation: Suggested Citation