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Financial fire sales as continuous-state complex contagion

Onaga, Tomokatsu, Caccioli, Fabio and Kobayashi, Teruyoshi (2023) Financial fire sales as continuous-state complex contagion. Physical Review Research, 5 (4). ISSN 2643-1564

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Identification Number: 10.1103/PhysRevResearch.5.043123

Abstract

Trading activities in financial systems create various channels through which systemic risk can propagate. An important contagion channel is financial fire sales, where a bank failure causes asset prices to fall due to asset liquidation, which in turn drives further bank defaults, triggering the next rounds of liquidation. This process can be considered as a complex contagion, yet it cannot be modeled using the conventional binary-state contagion models because there is a continuum of states representing asset prices. Here, we develop a threshold model of continuous-state cascades in which the states of each node are represented by real values. We show that the solution of a multistate contagion model, for which the continuous states are discretized, accurately replicates the simulated continuous state distribution as long as the number of states is moderately large. This discretization approach allows us to exploit the power of approximate master equations to trace the trajectory of the fraction of defaulted banks and obtain the distribution of asset prices that characterize the dynamics of fire sales through overlapping portfolios. We examine the accuracy of the proposed method using real data on asset-holding relationships in exchange-traded funds. Our methodology could contribute to evaluating and controlling systemic risk that would emerge in various real-world networked systems in the form of continuous-state complex contagion.

Item Type: Article
Official URL: https://journals.aps.org/prresearch/
Additional Information: © 2023 The Authors
Divisions: Systemic Risk Centre
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
Date Deposited: 30 Nov 2023 19:03
Last Modified: 07 Jul 2024 21:55
URI: http://eprints.lse.ac.uk/id/eprint/120898

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