The Cause, Effects, and Implications of Financial Contagion

The Cause, Effects, and Implications of Financial Contagion

Jonathan Lhost's Entry For The 2004 Moffatt Prize in Economics

Introduction

The study of financial contagion is growing in importance with the expanding global scope of financial markets. Financial contagion is defined as a shock to one country's asset market that causes changes in asset prices in another country's financial market. How does financial contagion occur, why is it important, and is there anything that can be done about it? Answers to these and other questions are important in developing an understanding of recent financial crises such as those in Asia and Latin America. Furthermore, it is in the world's interest to develop an understanding of how shocks can be transmitted between countries so that steps can be taken to reduce financial contagion and the instability it causes in emerging markets, markets that are already fragile and thus greatly need stability in order to develop and grow. This paper discusses a model that explains corridors of financial contagion, assesses the importance of the conclusions drawn from the model, and takes steps towards finding ways to reduce the instability of and caused by the world's financial markets.

In this paper, I start by laying out the key components of a model of financial contagion developed by Laura Kodres and Matthew Pritsker in their paper "A Rational Expectations Model of Financial Contagion."1 In this section, I will explain what financial contagion is and how it is transmitted between countries. In the second section, I will discuss the important conclusions that are drawn from the model presented in the first section: most significantly that financial contagion can occur between two countries that do not share common macroeconomic fundamentals. In the third section, I will talk about the implications of the conclusions drawn from the model, including the market inefficiencies related to financial contagion. In the final section, I shall discuss implications for the future-the ways in which we can attempt to reduce financial contagion, and thus reduce instability, in the future.

What is Financial Contagion and how is it transmitted?

Financial contagion, in this model, is defined generally as "a price movement in one market resulting from a shock in another market."2 Contagion can be defined more restrictively as "a shock in one country that generates price movements in other countries that are excessive relative to 'full information' fundamentals."3 The results of the model hold for both the more general and more restrictive definitions.

In the model that we are examining, it is assumed that there are three different types of investors: informed investors, uninformed investors, and liquidity traders (also called noise traders). Informed investors receive better information than all other investors about asset values and use this information in determining their optimal portfolio. Uninformed investors lack the information held by the informed investors. They try to infer the information held by the informed investors from asset prices, but are unable to do so precisely due to noise trading (the trading of noise traders explained below). The number of informed investors is quite small relative to the number of uninformed investors. The last group of traders, liquidity or noise traders, are traders who buy and sell assets to meet personal liquidity needs. Trading done by liquidity traders has nothing to do with the fundamental value of the traded assets.4

In a market, there are several different possible types of shocks. Information shocks occur when informed investors receive information that they use in selecting their optimal portfolios. Liquidity shocks occur when liquidity traders trade to meet their individual needs for liquidity. Each shock has several ways in which it affects the market: the expectations and the portfolio balance components of the price change. The expectations component of the price change reflects uninformed investors adjusting their expectations of asset values after informed investors trade based on new information they receive. The portfolio balance component of the price change measures the changes in asset prices due to the rebalancing of portfolios by uninformed investors based on their belief that the changes in asset prices do not reflect information.5

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