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A Theory of Slow-Moving Capital and Contagion

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  • Acharya, Viral V.
  • Shin, Hyun Song
  • Yorulmazer, Tanju

Abstract

Fire sales that occur during crises beg the question of why sufficient outside capital does not move in quickly to take advantage of fire sales, or in other words, why outside capital is so slow-moving. We propose an answer to this puzzle in the context of an equilibrium model of capital allocation. Keeping capital in liquid form in anticipation of possible fire sales entails costs in terms of foregone profitable investments. Set against this, those same profitable investments are rendered illiquid in future due to agency problems embedded with expertise. We show that a robust consequence of this trade-off between making investments today and waiting for arbitrage opportunities in future is the combination of occasional fire sales and limited stand-by capital that moves in only if fire-sale discounts are sufficiently deep. An extension of our model to several types of investments gives rise to a novel channel for contagion where sufficiently adverse shocks to one type can induce fire sales in other types that are fundamentally unrelated, provided arbitrage activity in these investments is sourced from a common pool of capital.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7147.

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Date of creation: Jan 2009
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Handle: RePEc:cpr:ceprdp:7147

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Keywords: arbitrage; crises; fire sales; illiquidity; spillover;

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Citations

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Cited by:
  1. Morrison, Alan D. & White, Lucy, 2013. "Reputational contagion and optimal regulatory forbearance," Journal of Financial Economics, Elsevier, vol. 110(3), pages 642-658.
  2. Alvarez, Fernando E & Lippi, Francesco, 2011. "Persistent Liquidity Effects and Long Run Money Demand," CEPR Discussion Papers 8650, C.E.P.R. Discussion Papers.
  3. Guembel, Alexander & Sussman, Oren, 2010. "Liquidity, Contagion and Financial Crisis," TSE Working Papers 10-240, Toulouse School of Economics (TSE).
  4. Morrison, Alan D. & White, Lucy, 2010. "Reputational contagion and optimal regulatory forbearance," Working Paper Series 1196, European Central Bank.
  5. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2009. "Crisis Resolution and Bank Liquidity," NBER Working Papers 15567, National Bureau of Economic Research, Inc.
  6. Dong Lou & Hongjun Yan & Jinfan Zhang, 2013. "Anticipated and Repeated Shocks in Liquid Markets," Review of Financial Studies, Society for Financial Studies, vol. 26(8), pages 1891-1912.
  7. Shakill Hassan & Sean Smith, 2011. "The Rand as a Carry Trade Target: Risk, Returns and Policy Implications," Working Papers 235, Economic Research Southern Africa.
  8. Lei Zhang & Hanno Lustig & Andrea Eisfeldt, 2013. "Financial Expertise and Asset Prices," 2013 Meeting Papers 1347, Society for Economic Dynamics.

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