Contagion of Fire Sale on Security-Trader Network

This paper studies the contagion of fire sale across asset markets through the price effect. When a distressed trader liquidates her stock holding quickly, the fire sale will depress the asset price and other shareholders will incur mark-to-market losses. If the losses are large enough, these shareholders may also have to liquidate other assets they hold, and the liquidation can spread out and become contagious over the financial markets. We show that contagion happens only when the network is neither too sparse nor too dense. The simulation results confirmed this, and also suggest that the asset market networks exhibit a robust-yet-fragile tendency: when the financial network is relatively dense and hence the probability of contagion becomes small, the consequence can be disastrous (close to 100% bankruptcy rate) if it happens. I also examine the effects of front running on contagion and show that front running aggravates both probability of contagion and its consequence. The complex asset markets are depicted by random graph-based bipartite networks, which allow for multiple assets and multiple agents with arbitrary portfolios and distinguishes this paper from the the current literature on contagion of default (counterparty risk). By using the techniques of generating functions, the probabilities of widespread contagions and their extent can be analytically derived.