Financial contagion in network economies and asset prices

Abstract

This paper studies intertemporal asset pricing in network economies when distress shocks can propagate through the network, similarly to epidemic outbreaks. Two classes of equilibria exist. In the first, idiosyncratic shocks are diversifiable and don’t affect valuations: CCAPM applies. In the second, idiosyncratic shocks generate non-diversifiable long-run cascades of shocks (financial pandemics) that introduce a new risk premium component unexplained by traditional systematic factors. We derive closed-solutions for asset prices as a function of the network properties and discuss their properties. After a structural break (1984), we find evidence of a network risk premium that is statistically and economically significant.