The Cause, Effects, and Implications of Financial Contagion

So how is the demand for assets in one market affected by price changes in a different market? The Slutsky income and substitution effects from the standard Slutsky equation are two ways in which demand for assets in one market is affected when asset prices change in another market. These two effects are not the focus of the model and will henceforth be ignored.6 An effect that is present in our model is the information effect. The information effect occurs when either informed investors' information or liquidity trading is correlated across markets, causing price changes in one market to possibly reflect information about asset values in other markets. When informed investors' information is correlated across markets, uninformed investors in one market see price changes in another market and perceive the price changes to be a result of information that is correlated with asset values in other markets.7 When liquidity trading is correlated across markets, "Price changes in one market will affect uninformed investors' assessment of whether price changes in other markets are due to informed investors' information in those markets or due to noise."8 The uninformed investors will make different decisions with regard to their portfolios if they perceive that the price changes reflect informed investors' information, which could have implications for asset values-as opposed to reflecting noise trading, in which case no information on fundamentals is revealed.9

The shocks and the effects that shocks have on various markets result in three distinct channels of contagion: the correlated information channel, the correlated liquidity shock channel, and the cross-market rebalancing channel. Shocks are transmitted through the correlated information channel when uninformed investors in one market think price changes in another market reflect informed investors' information about fundamentals, following from the information effect discussed above. This channel of contagion is more conceivable when considering closely linked markets, but does little in explaining financial contagion between weakly linked markets. Contagion occurs through the correlated liquidity shock channel when liquidity traders seeking liquidity sell assets in multiple markets. However, seeing as liquidity is most readily available in developed markets and financial contagion hits emerging markets the hardest, the liquidity shock channel on its own cannot explain contagion. The channel that seems to best explain financial contagion is the cross-market rebalancing channel. Shocks occurring in one market are transmitted to other markets thought the cross-market rebalancing channel when investors react to a shock by readjusting their portfolios in other markets.10 Kodres and Pritsker explain, "Contagion occurs through this channel when market participants are hit with an idiosyncratic shock in one country and transmit the shock abroad by optimally rebalancing their portfolio's exposures to macroeconomic risks through other countries' markets."11

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