Contagion as a wealth effect

Albert S. Kyle, Wei Xiong

Research output: Contribution to journalArticle

329 Scopus citations

Abstract

Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined (numerically) as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management.

Original languageEnglish (US)
Pages (from-to)1401-1440
Number of pages40
JournalJournal of Finance
Volume56
Issue number4
DOIs
StatePublished - Aug 2001

All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance
  • Economics and Econometrics

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