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Price-mediated contagion with endogenous market liquidity

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  • Zhiyu Cao
  • Zachary Feinstein

Abstract

Price-mediated contagion occurs when a positive feedback loop develops following a drop in asset prices which forces banks and other financial institutions to sell their holdings. Prior studies of such events fix the level of market liquidity without regards to the level of stress applied to the system. This paper introduces a framework to understand price-mediated contagion in a system where the capacity of the market to absorb liquidated assets is determined endogenously. In doing so, we construct a joint clearing system in interbank payments, asset prices, and market liquidity. We establish mild assumptions which guarantee the existence of greatest and least clearing solutions. We conclude with detailed numerical case studies which demonstrate the, potentially severe, repercussions of endogenizing the market liquidity on system risk.

Suggested Citation

  • Zhiyu Cao & Zachary Feinstein, 2023. "Price-mediated contagion with endogenous market liquidity," Papers 2311.05977, arXiv.org.
    • Handle: RePEc:arx:papers:2311.05977
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    References listed on IDEAS

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    1. Matthew Elliott & Benjamin Golub & Matthew O. Jackson, 2014. "Financial Networks and Contagion," American Economic Review, American Economic Association, vol. 104(10), pages 3115-3153, October.
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    9. Tathagata Banerjee & Zachary Feinstein, 2019. "Price mediated contagion through capital ratio requirements with VWAP liquidation prices," Papers 1910.12130, arXiv.org, revised Feb 2021.
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    11. Maxim Bichuch & Zachary Feinstein, 2020. "Endogenous inverse demand functions," Papers 2012.08002, arXiv.org, revised Apr 2022.
    12. Feinstein, Zachary & Hałaj, Grzegorz, 2023. "Interbank asset-liability networks with fire sale management," Journal of Economic Dynamics and Control, Elsevier, vol. 155(C).
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    16. Zhiyu Cao & Zihan Chen & Prerna Mishra & Hamed Amini & Zachary Feinstein, 2023. "Modeling Inverse Demand Function with Explainable Dual Neural Networks," Papers 2307.14322, arXiv.org, revised Oct 2023.
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