Working Paper: NBER ID: w19381
Authors: Nicolae Grleanu; Stavros Panageas; Jianfeng Yu
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. Despite the ex-ante 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.
Keywords: Market Integration; Asset Pricing; Leverage; Contagion
JEL Codes: G01; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Limited market integration (G19) | higher risk premia (G19) |
| Participation costs (D23) | investor behavior (G41) |
| Participation costs (D23) | asset prices (G19) |
| Local shocks (D52) | contagion effects in distant markets (F65) |
| Diverse investment strategies (G11) | endogeneity of leverage (G32) |