Abstract
We develop a structural model for the analysis of systemic risk in financial markets based on asset price contagion. Specifically, we describe a mechanism of contagion where exogenous random shocks to individual agents in an economy force portfolio rebalancing and endogenously impact asset prices. This, in turn, creates a chain reaction as downstream agents trade in reaction to price changes. In our setting, this contagion is modulated through a bipartite financial holding network, which describes the relationships between agents and a universe of tradable assets through their portfolio holdings. Our approach quantifies the robustness of different financial holding networks to shocks propagated by asset price contagion by measuring the sensitivity of asset prices to exogenous shocks. We illustrate that leverage plays a critical role in asset price contagion. In particular, in low-leverage economies, “mutual fund” networks (where agents hold a common, diversified portfolio of risky assets) are desirable to mitigate contagion. On the other hand, in high-leverage economies, “isolated” networks (where agents hold maximally diverse, unrelated portfolios) become beneficial.