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Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

Author

Listed:
  • Stavros Panageas

    (University of Chicago - Booth School of)

  • Jianfeng Yu

    (University of Minnesota)

  • Nicolae Garleanu

    (University of California, Berkeley)

Abstract

We propose a unied model of limited market integration, asset-price determination, leveraging, and contagion. Investors and firms are located on a circle, and access to markets involves participation costs that increase with distance. Despite the exante symmetry of investors, their strategies may (endogenously) exhibit diversity, with some investors in each location following high-leverage, high-participation, and high-cost strategies and some unleveraged, low-participation, and low-cost strategies. The capital allocated to high-leverage strategies may be vulnerable even to small changes in market-access costs, which can lead to discontinuous price drops, de-leveraging, and portfolio- flow reversals. Moreover, the market is subject to contagion, in that an adverse shock to investors at a subset of locations affects prices everywhere.

Suggested Citation

  • Stavros Panageas & Jianfeng Yu & Nicolae Garleanu, 2014. "Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion," 2014 Meeting Papers 711, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:711
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    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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