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American Economic Review Vol. 105 No. 7 2015

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

Nicolae Gârleanu1; Stavros Panageas2; Jianfeng Yu3

1 Haas School of Business, University of California, Berkeley, CA 94720-1900 (e-mail: ) · 2 Booth School of Business, University of Chicago, 5807 S. Woodlawn Avenue, Chicago, IL 60637 (e-mail: ) · 3 Carlson School of Business, University of Minnesota, 321 19th Avenue South, Suite 3-122, Minneapolis, MN 55455, and Chinese University of Hong Kong, Shenzhen (e-mail: )

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.

DOI
10.1257/aer.20131076
Volume
105
Issue
7
Pages
1979-2010
Language
en
Sources
crossref openalex bibtex:phds-export.bib

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