Abstract
We construct a continuous time model for price-mediated contagion precipitated by a common exogenous stress to the banking book of all firms in the financial system. In this setting, firms are constrained so as to satisfy a risk-weight based capital ratio requirement. We use this model to find analytical bounds on the risk-weights for assets as a function of the market liquidity. Under these appropriate risk-weights, we find existence and uniqueness for the joint system of firm behavior and the asset prices. We further consider an analytical bound on the firm liquidations, which allows us to construct exact formulas for stress testing the financial system with deterministic or random stresses. Numerical case studies are provided to demonstrate various implications of this model and analytical bounds.
| Original language | English |
|---|---|
| Pages (from-to) | 449-463 |
| Number of pages | 15 |
| Journal | European Journal of Operational Research |
| Volume | 281 |
| Issue number | 2 |
| DOIs | |
| State | Published - Mar 1 2020 |
ASJC Scopus subject areas
- General Computer Science
- Modeling and Simulation
- Management Science and Operations Research
- Information Systems and Management
Keywords
- Finance
- Financial contagion
- Fire sales
- Risk-weighted assets
- Stress testing