Illiquidity Comovement and Market Crisis.

Area of Science:

• Financial Economics
• Market Dynamics
• Risk Management

Background:

• Unlinked markets typically lack common fundamental factors, suggesting independent behavior.
• Existing models often struggle to explain contagion between markets without direct linkages.
• Understanding contagion mechanisms is crucial for financial stability.

Purpose of the Study:

• To develop a rational expectation equilibrium model explaining financial contagion between unlinked markets.
• To identify the role of cross-asset linkages in transmitting fundamental risk.
• To provide a novel explanation for liquidity comovement and market crises.

Main Methods:

• Construction of a three-asset rational expectation equilibrium model.
• Introduction of an intermediate asset connecting two otherwise unlinked risky assets via cross fundamentals.
• Analysis of how fundamental risk is transmitted through investor behavior.

Main Results:

• The model demonstrates that cross fundamentals facilitate the transmission of fundamental risk between unlinked markets.
• This risk transmission leads to liquidity comovement, where liquidity shocks in one asset affect others.
• An initial liquidity shock can decrease liquidity and price informativeness in connected, yet unlinked, assets.

Conclusions:

• Cross-asset fundamental linkages provide a channel for financial contagion between seemingly independent markets.
• Liquidity comovement driven by this mechanism offers a new explanation for contagion in idiosyncratic assets.
• The findings highlight the interconnectedness of financial markets, even in the absence of shared fundamentals.