Asymmetric Price Movements and Borrowing Constraints: A Rational Expectations Equilibrium Model of Crises, Contagion, and Confusion

Abstract

This study proposes a rational expectations equilibrium model of crises and contagion in an economy with information asymmetry and borrowing constraints. Consistent with empirical observations, the model finds: (1) Crises can be caused by small shocks to fundamentals; (2) market return distributions are asymmetric; and (3) correlations among asset returns tend to increase during crashes. The model also predicts: (1) Crises and contagion are likely to occur after small shocks in the intermediate price region; (2) the skewness of asset price distributions increases with information asymmetry and borrowing constraints; and (3) crises can spread through investor borrowing constraints. Copyright 2005 by The American Finance Association.

Speculation and Hedging in Segmented Markets

“…Watanabe (2008) and Biais, Bossaerts, and Spatt (2010) extend Admati's model to an overlapping generation setting to study the effect of asymmetric information and supply shocks on portfolio choice, return volatility, and trading volume. Yuan (2005) introduces borrowing constraints into a two-asset model and shows how trading can cause contagion across two fundamentally independent markets. Van Nieuwerburgh and Veldkamp (2009Veldkamp ( , 2010 show that the interactions between the multi-asset portfolio problem and the information acquisition problem help to explain the home-bias puzzle and the underdiversification puzzle.…”

Equity market contagion during the global financial crisis: Evidence from the world's eight largest economies

“…A crisis in one country may give a "wake-up call" to international investors to reassess the risks in other countries, and uninformed or less informed investors may find it difficult to extract the informed signal from the falling price, and follow the strategies of better informed investors generating excess co-movements across the markets (Goldstein, 1998;Yuan, 2005;Pasquariello, 2007). Tthe degree of (non)anticipation of a crisis by investors is crucial for existence of contagion because of investors' attention allocation (Mondria and Quintana-Domeque, 2012).…”

Multivariate contagion and interdependence

“…This would enable comparison of the results here with models with a bivariate structure for example. This is not pursued here as in the first instance it is assumed that contagion is in the most extreme form as alluded to by the theoretical models of Boyer et al (2006) and Yuan (2005), affecting all asset markets in the sample.…”

“…These include models based on herding behaviour, information asymmetries or cascades Mendoza, 2000, andYuan, 2005), portfolio re-balancing (Kodres and Pritsker, 2002), wealth constraints (Kyle andXiong, 2001 andYuan, 2005) and borrowing constraints (Boyer, Kumagai and Yuan, 2006). 2 Although it is difficult to evaluate empirically the concepts these papers suggest, they all have in common that asset markets that appear not related develop an additional linkage arising through circumstances in the international financial environment.…”

“…Fratzscher (1999Fratzscher ( , 2003 uses a random effects panel model to examine contagion in currency markets, while numerous other papers draw on the exchange pressure index methodology of Wypolz (1995,1996), also for currency markets (see also Van Rijckeghem andWeder, 2003 andReinhart, 1996). Alternative multivariate approaches include those based on vector autoregressions (Favero and Giavazzi, 2002); coexceedances (Bae, Karolyi andStultz, 2003 andSchulze, 2005); observed and latent factors (Dungey and Martin, 2004, Corsetti, Pericoli and Sbracia, 2001, 2005and Bekaert, Harvey and Ng, 2005; and changes in the determinant of covariance matrices (Rigobon, 2003).…”