The Company You Keep: Foreign Investors, Risk Taking, and International Contagion

Abstract

In this paper we construct a theory of financial market runs with heterogeneous investors. We use the model to investigate how exposure to liquidity shocks and risk taking for one investor impacts the behavior of the other type of investor. We show that investors who are not directly exposed to liquidity shocks, but who hold assets in markets where exposed investors participate, respond to increased risk levels of exposed investors by themselves being more sensitive to the shocks, even though these shocks do not impact their portfolio directly. The strength of this effect depends crucially on financial market depth: shocks which force liquidations from exposed investors have a larger impact on asset prices, and thus the portfolios of non-exposed investors, in less liquid markets. These results illuminate some important mechanisms regarding the international transmission of financial market turbulence between investors.

Keywords: market liquidity; contagion

JEL Classification: F30; F44; E44