Contagion of self-fulfilling financial crises due to diversification of investment portfolios

Itay Goldstein*, Ady Pauzner

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

118 Scopus citations

Abstract

We look at two countries that have independent fundamentals, but share the same group of investors. Each country might face a self-fulfilling crisis: Agents withdrawing their investments fearing that others will. A crisis in one country reduces agents wealth. This makes them more averse to the strategic risk associated with the unknown behavior of other agents in the second country, increasing their incentive to withdraw their investments. Consequently, the probability of a crisis there increases. This generates a positive correlation between the returns in the two countries. Since diversification affects returns in our model, its welfare implications are non-trivial.

Original languageEnglish
Pages (from-to)151-183
Number of pages33
JournalJournal of Economic Theory
Volume119
Issue number1 SPEC. ISS.
DOIs
StatePublished - Nov 2004

Keywords

  • Capital controls
  • Contagion
  • Coordination failures
  • Diversification
  • Financial crises
  • Global games
  • Globalization
  • Strategic risk
  • Wealth effect

Fingerprint

Dive into the research topics of 'Contagion of self-fulfilling financial crises due to diversification of investment portfolios'. Together they form a unique fingerprint.

Cite this