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Fire sales, endogenous risk and price-mediated contagion

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Systemic Risk: Mathematical Modelling and Interdisciplinary Approaches

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.

This talk is part of the Isaac Newton Institute Seminar Series series.

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