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Fire sales, endogenous risk and price-mediated contagion

Thursday 25th September 2014 - 10:00 to 10:45
INI Seminar Room 1
Session Title: 
Fire Sales and Price-Mediated Contagion
Fire sales of assets during financial crises have been recognized as an important channel of contagion and amplification of losses We present a simple model of feedback and contagion through fire sales triggered by an initial macro-shock to a set of leveraged portfolios with common exposures and subject to leverage constraints. We show that the threshold nonlinearity inherent in the onset of fire sales plays a key role in the amplifying of shocks to portfolios, and investigate the role of portfolio constraints -leverage constraints and capital ratios- and the tradeoff between diversification and 'diversity' in determining the magnitude of contagion. The competition between contagion across portfolios and market impact of liquidation ('self-contagion') leads to a non-monotone dependence of the system-wide losses on parameters describing portfolio concentration, with different results depending on the severity of the stress scenarios considered. In particular, the model indicates that, for a given level of severity of the stress, the onset of contagion occurs when leverage is allowed to exceed a critical level, a criterion which can be used to calibrate regulatory constraints on leverage.
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Presentation Material: 
University of Cambridge Research Councils UK
    Clay Mathematics Institute London Mathematical Society NM Rothschild and Sons