Correlated liquidity shocks, financial contagion and asset price dynamics

Recent literature shows how the destabilising e¤ect of portfolio insurance activity on the price of the underlying asset depends on the liquidity of the asset market. We build a simple model where market timers shift capital around asset markets in order to exploit gains from temporary excess-volatility of asset prices. In this way, market timers increase the liquidity of asset markets reducing the excess volatility, while they increase the cross-market correlation, whereas long-ranged financial contagion eventually occurs. We show how liquidity of asset markets, cross-market correlation and excess volatility of asset prices depend on structural parameters of asset markets.