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Price-mediated contagion with endogenous market liquidity

Author

Listed:
  • Zhiyu Cao

    (Stevens Institute of Technology)

  • Zachary Feinstein

    (Stevens Institute of Technology)

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, 2025. "Price-mediated contagion with endogenous market liquidity," Mathematics and Financial Economics, Springer, volume 19, number 4, September.
    • Handle: RePEc:spr:mathfi:v:19:y:2025:i:1:d:10.1007_s11579-024-00377-9
    DOI: 10.1007/s11579-024-00377-9
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    References listed on IDEAS

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    11. Banerjee, Tathagata & Feinstein, Zachary, 2021. "Price mediated contagion through capital ratio requirements with VWAP liquidation prices," European Journal of Operational Research, Elsevier, vol. 295(3), pages 1147-1160.
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    More about this item

    Keywords

    Systemic risk; Financial contagion; Fire sales; Market liquidity;
    All these keywords.

    JEL classification:

    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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