Paper: arXiv 2311.05977
Authors: Zhiyu Cao, Zachary Feinstein
Abstract
Price-mediated contagion occurs when a positive feedback loop develops following a drop in asset prices which forces banks and other financial institutions to sell their holdings. Prior studies of such events fix the level of market liquidity without regards to the level of stress applied to the system. This paper introduces a framework to understand price-mediated contagion in a system where the capacity of the market to absorb liquidated assets is determined endogenously. In doing so, we construct a joint clearing system in interbank payments, asset prices, and market liquidity. We establish mild assumptions which guarantee the existence of greatest and least clearing solutions. We conclude with detailed numerical case studies which demonstrate the, potentially severe, repercussions of endogenizing the market liquidity on system risk.
Complexity vs Empirical Score
- Math Complexity: 8.5/10
- Empirical Rigor: 3.5/10
- Quadrant: Lab Rats — theoretically deep, empirically untested
Why this score: The paper provides a rigorous mathematical framework extending lattice-theoretic clearing vectors (Eisenberg-Noe style) to incorporate endogenous market liquidity and asset prices. While theoretically robust with existence proofs and numerical case studies, it relies primarily on simulated scenarios rather than extensive empirical backtesting with historical market data.
Research Flowchart
flowchart TD
A["Research Question: Impact of Endogenous Market Liquidity on Price-Mediated Contagion"] --> B["Inputs: Interbank Network Data, Asset Holdings & Financial Stress Scenarios"]
B --> C["Model Construction: Joint Clearing System (Payments, Asset Prices & Endogenous Liquidity)"]
C --> D["Theoretical Proof: Establish Existence of Greatest & Least Clearing Solutions"]
D --> E["Numerical Case Studies: Simulate Systemic Risk & Asset Liquidation"]
E --> F["Key Outcome: Endogenous Liquidity Significantly Amplifies Feedback Loops & Systemic Risk"]