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A Theory of Slow-Moving Capital and Contagion

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

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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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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  1. Mark Mitchell & Lasse Heje Pedersen & Todd Pulvino, 2007. "Slow Moving Capital," NBER Working Papers 12877, National Bureau of Economic Research, Inc.
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  13. Rigobon, Roberto, 2002. "The curse of non-investment grade countries," Journal of Development Economics, Elsevier, vol. 69(2), pages 423-449, December.
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  15. Graciela Kaminsky & Sergio L. Schmukler, 2002. "Emerging Market Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?," World Bank Economic Review, World Bank Group, vol. 16(2), pages 171-195, August.
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