Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion
American Economic Review
vol. 105,
no. 7, July 2015
(pp. 1979-2010)
Abstract
We propose a unified 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. Due to a complementarity between participation and leverage decisions, the equilibrium may exhibit diverse leverage and participation choices across investors, although investors are ex ante identical. Small changes in market-access costs can cause a change in the type of equilibrium, leading to discontinuous price changes, deleveraging, and portfolio-flow reversals. Moreover, the market is subject to contagion—an adverse shock to investors in some locations affects prices everywhere. (JEL D83, G11, G12, G32, G35)Citation
Gârleanu, Nicolae, Stavros Panageas, and Jianfeng Yu. 2015. "Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion." American Economic Review, 105 (7): 1979-2010. DOI: 10.1257/aer.20131076Additional Materials
JEL Classification
- D83 Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
- G11 Portfolio Choice; Investment Decisions
- G12 Asset Pricing; Trading Volume; Bond Interest Rates
- G32 Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- G35 Payout Policy