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Contagion as a Wealth Effect

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  • Albert S. Kyle
  • Wei Xiong

Abstract

Financial contagion is described as a wealth effect in a continuous‐time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long‐term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined (numerically) as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management.

Suggested Citation

  • Albert S. Kyle & Wei Xiong, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, August.
  • Handle: RePEc:bla:jfinan:v:56:y:2001:i:4:p:1401-1440
    DOI: 10.1111/0022-1082.00373
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