Illiquidity Comovement and Market Crisis.

Abstract

This paper presents a rational expectation equilibrium model to explore how the financial contagion occurs between the unlinked markets that do not share common fundamentals. In the proposed model, the authors assume two of the three risky assets share no common fundamental factors, but are connected by one intermediate asset via cross fundamentals. Through this channel, investors transmit fundamental risk from one asset to another by dint of the cross fundamentals. This mechanism causes liquidity comovement and subsequently becomes a source of market crisis: Through the contagion mechanism, an initial liquidity shock in one asset can result in a drop tendency in liquidity and price informativeness for another asset. Such comovement in liquidity offers a new explanation for idiosyncratic assets in financial contagion.