We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more “complete ” interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.

A central idea in macroeconomic theory is that negative price effects from the leverage-induced forced sale of durable goods can amplify negative shocks and reduce economic activity. We examine this idea by estimating the effect of U.S. foreclosures in 2008 and 2009 on house prices, residential investment, and durable consumption. We show that states that require judicial process for a foreclosure sale have significantly lower rates of foreclosures relative to states that have no such requirement. Using state laws requiring a judicial foreclosure as an instrument for actual foreclosures, as well as a regression discontinuity design around state borders with differing foreclosure laws, we show that foreclosures have a large negative impact on house prices. Foreclosures also lead to a significant decline in residential investment and durable consumption. The magnitudes of the effects are large, suggesting that foreclosures have been an important factor in weak house price, residential investment, and durable consumption patterns during and after the Great Recession of 2007 to 2009.

explicit permission, provided that full credit including © notice is given to the source. This paper also can be downloaded without charge from the

This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Risk Appetite and Exchange Rates

I discuss some ways in which ideas from psychology may be helpful for thinking about the financial crisis of 2007-2008. I focus on three aspects of the crisis: the surge in house prices in the years leading up to 2006; the large positions in subprime-linked securities that many banks had accumulated by 2007; and the dramatic decline in value of many risky asset classes during the crisis period. I review a number of psychology-based mechanisms, but emphasize two, both of which have already been extensively studied in behavioral finance and behavioral economics: over-extrapolation of past price changes; and belief manipulation. 1 Yale School of Management. This essay is in preparation for Financial Innovation and Crisis (MIT Press, Michael Haliassos, ed.). It is based on an invited talk at a conference in 2009 on the occasion of the awarding of the Deutsche Bank Prize in Financial Economics to Robert Shiller. I am grateful to Malcolm

We examine the risk-taking behavior of money market funds during the financial crisis of 2007-10. We show that as a result of the crisis: (1) money market funds experienced an unprecedented expansion in their risk-taking opportunities; (2) funds had strong incentives to take on risk because fund inflows were highly responsive to fund returns; (3) funds spon-sored by financial intermediaries that also offer non-money market mutual funds and other financial services took on less risk, consistent with the sponsors ’ concerns over possible neg-ative spillovers to the rest of their business in case of a run. Moreover, funds sponsored by financial intermediaries with limited financial resources took on less risk, consistent with the sponsors ’ limited ability to stop runs reducing the incentives for risk taking. These results suggest that money market funds ’ risk-taking decisions trade off the benefits of fund inflows

Convergence trades exploit temporary mispricing by simultaneously buying relatively underpriced assets and selling short relatively overpriced assets. This paper studies optimal convergence trades under both recurring and non-recurring arbitrage opportunities represented by continuing and ‘stopped ’ cointegrated price processes and considers both fixed and stochastic (Poisson) horizons. We demonstrate that conventional long-short delta neutral strategies are generally suboptimal and show that it can be optimal to simultaneously go long (or short) in two mispriced assets. We also find that the optimal portfolio holdings critically depend on whether the risky asset position is liquidated when prices converge. Our theoretical results are illustrated using parameters estimated on pairs of Chinese bank shares that are traded on both the Hong Kong and China stock exchanges. We find that the optimal convergence trade strategy can yield economically large gains compared to a delta neutral strategy. Key words: convergence trades; risky arbitrage; delta neutrality; optimal portfolio choice ∗The paper was previously circulated under the title Optimal Arbitrage Strategies. We thank the Editor, Pietro Veronesi, and an anonymous referee for detailed and constructive comments on the paper. We also thank Alberto Jurij

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 exante symmetry of investors, their strategies may (endogenously) exhibit diversity, with some investors in each location following high-leverage, high-participation, and highcost 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.

Acknowledgments: The paper has benefited greatly from helpful comments by Joseph Weber

We define CoVaR as the Value-at-Risk (VaR)offinancial institutions conditional on other institutions being under distress. The increase of CoVaR relative to VaR measures spillover risk among institutions. We estimate CoVaR using quantile regressions and document significant CoVaR increases among financial institutions. We identify six risk factors that allow institutions to offload tail risk, and show that such hedging reduces the wedge between CoVaR and VaR. We argue that financial institutions should report CoVaRs in addition to VaRs, and draw implications for risk management, regulation, and systemic risk. We define Co-Expected Shortfall as a sum of CoVaRs.