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Default and Systemic Risk in Equilibrium

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  • Agostino Capponi
  • Martin Larsson
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    Abstract

    We develop a finite horizon continuous time market model, where risk averse investors maximize utility from terminal wealth by dynamically investing in a risk-free money market account, a stock written on a default-free dividend process, and a defaultable bond, whose prices are determined via equilibrium. We analyze financial contagion arising endogenously between the stock and the defaultable bond via the interplay between equilibrium behavior of investors, risk preferences and cyclicality properties of the default intensity. We find that the equilibrium price of the stock experiences a jump at default, despite that the default event has no causal impact on the dividend process. We characterize the direction of the jump in terms of a relation between investor preferences and the cyclicality properties of the default intensity. We conduct similar analysis for the market price of risk and for the investor wealth process, and determine how heterogeneity of preferences affects the exposure to default carried by different investors.

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    File URL: http://arxiv.org/pdf/1108.1133
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1108.1133.

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    Date of creation: Aug 2011
    Date of revision: Dec 2011
    Handle: RePEc:arx:papers:1108.1133

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    Web page: http://arxiv.org/

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    1. Freixas, Xavier & Parigi, Bruno & Rochet, Jean Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2325, C.E.P.R. Discussion Papers.
    2. Cvitanic Jaksa & Malamud Semyon, 2010. "Relative Extinction of Heterogeneous Agents," The B.E. Journal of Theoretical Economics, De Gruyter, De Gruyter, vol. 10(1), pages 1-23, February.
    3. Napp, Clotilde & Malamud, Semyon & Jouini, Elyès & Cvitanic, Jaksa, 2012. "Financial Markets Equilibrium with Heterogeneous Agents," Economics Papers from University Paris Dauphine, Paris Dauphine University 123456789/4724, Paris Dauphine University.
    4. Jaksa Cvitanic & Fernando Zapatero, 2004. "Introduction to the Economics and Mathematics of Financial Markets," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262532654, December.
    5. Bernard Dumas, . "Two-Person Dynamic Equilibrium: Trading in the Capital Market," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 07-88, Wharton School Rodney L. White Center for Financial Research.
    6. Paolo Dai Pra & Wolfgang J. Runggaldier & Elena Sartori & Marco Tolotti, 2007. "Large portfolio losses: A dynamic contagion model," Papers 0704.1348, arXiv.org, revised Mar 2009.
    7. Harjoat S. Bhamra & Raman Uppal, 2009. "The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(6), pages 2303-2330, June.
    8. Krishnamurthy, Arvind, 2000. "Comment on Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 32(3), pages 639-40, August.
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