An Overlapping-Arcs Model of Partial Integration,Asset Prices, and Capital Allocation

Abstract

Investors, firms, and intermediaries are located on a circle. Intermediaries facilitate risk sharing by allowing investors at their location to invest in firms at other locations. Participation in distant markets is costly, the more so the more distant these markets. Although investors at any location are identical to each other, we find that the financial sector may exhibit diversity, with some financial intermediaries offering high-leverage, high-participation, and high-fee structures and some intermediaries offering unlevered, low-participation, and low-fee structures. The high-leverage strategies are vulnerable to even small increases in the costs of accessing markets, leading to discontinuous price drops and portfolio-flow reversals. Moreover, an adverse shock to intermediaries at a subset of locations causes contagion, in the sense that it affects prices everywhere.