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Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion ∗ (2014)
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BibTeX
@MISC{Gârleanu14financialentanglement:,
author = {Nicolae Gârleanu and Stavros Panageas and Jianfeng Yu},
title = {Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion ∗},
year = {2014}
}
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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 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.
Keyphrases
incomplete integration financial entanglement asset-price determination location affect price small change portfolio-flow reversal limited market integration discontinuous price drop market-access cost unified model exhibit diversity adverse shock highcost strategy low-cost strategy participation cost exante symmetry high-leverage strategy
