Price Deviation from Fundamentals and Systemic Risk

Abstract:

The economy is inherently a large-scale complex system of which the financial markets are an important subcomponent of since instability in the financial markets often spills over to the rest of the system. We focus on formulating a dynamic system model of the financial sector to describe the interactions of the leveraged sector (e.g. investment banks, hedge funds, etc.) and the unleveraged sector (e.g. pension funds) when investing in the real economy. In our model, the leveraged sector (L) can borrow money from the unleveraged sector (U) in order to invest in a risky asset which reflects an investment in the real economy. The unleveraged sector (U) can invest both in the risky asset directly as well as in short term bonds issued by the leveraged sector. Both players are myopic but their optimization problems differ due to their different economic functions in the market: L maximizes his return on equity subject to a Value at Risk constraint whereas U maximizes his CARA utility. We show that L's behavior results in pro- cyclical demand for the risky assets due to wealth effects from past risky asset dividends; this in turn causes the price of the risky asset to deviate from its exogenously determined fundamental value in a boom-bust fashion. Furthermore, we show that in such a setup, exogenous dividend shocks lead to larger price effects when more of the risky asset supply is held by L. Moreover, we examine whether the interactions between U and L introduce autocorrelation in risky asset returns and present possible definitions of systemic risk buildup.

Biography:

Stavros Valavanis is currently a PhD student at MIT supervised by Professors Munther Dahleh and Andrew Lo. He is affiliated with both LIDS and the MIT-Sloan Laboratory for Financial Engineering and his research interests are interdisciplinary in nature: they primarily involve statistical inference and systems theory as applied to problems in financial economics. Currently, he is working on creating a new paradigm for understanding and controlling systemic risks in the financial markets in a dynamic stochastic general equilibrium setting which reflects today's market realities of non-passive leveraged financial intermediaries fueled by short term debt. Stavros also holds a BS and an MEng in Electrical Engineering and Computer Science from MIT.