Imperfect competition, information heterogeneity, and financial contagion

Financial contagion is the propagation of a shock to one security across other fundamentally unrelated securities. In this paper, we examine how heterogeneity of insiders ’ information about fundamentals may induce ex-cess comovement among asset prices, i.e., beyond the extent justified by the structure of the economy. We develop a model of multi-asset trading, populated by a number of informed strategic speculators facing a trade-off between the maximization of short- versus long-term utility of their wealth, uninformed market-makers, and liquidity traders, in which the liquidation values of the available securities depend on idiosyncratic as well as system-atic sources of risk. We show that, even in a setting where such insiders are rational, risk-neutral, and financially unconstrained, financial contagion can be an equilibrium outcome of a semi-strong efficient market, if and only if they receive heterogeneous information about those sources of risk and strate-gically trade on it. Rational market-makers use the observed aggregate orde