Contagion as a Wealth Effect

TLDR

Financial contagion is modeled as a wealth effect in a continuous‑time framework with two risky assets and three trader types—noise traders, long‑term liquidity providers, and logarithmic‑utility convergence traders. Convergence traders liquidate positions in both markets when they incur losses, triggering the contagion mechanism. This contagion increases return volatility and correlation, erodes portfolio diversification benefits, and poses challenges for risk management.

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.