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A rational expectations model of financial contagion

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Author Info
Laura E. Kodres
Matthew Pritsker
Abstract

We develop a multiple asset rational expectations model of asset prices to study the determinants of financial market contagion, and to provide an explanation for the pattern of contagion during the Asian financial crisis. Our findings show that the pattern and severity of financial contagion depends on the size of markets' sensitivities to common macroeconomic risk factors. The amount of information asymmetry within a financial market also increases its susceptibility to contagion. We focus on contagion through the cross-market hedging of macroeconomic risks. Through this channel, idiosyncratic shocks in one market are transmitted to others. Interestingly, contagion can occur between markets that have no macroeconomic risks in common. In addition, contagion occurs in the absence of any news, and before the macroeconomic risk factors are realized. Because contagion occurs through hedging, the pattern of contagion is strongly influenced by the presence or absence of derivatives markets for unbundling and hedging the macroeconomic risks. Errors in market participants' beliefs about dynamic hedging activity influence the pattern of contagion and, in some cases, strongly magnify the size of the contagious price responses.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1998-48.

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Date of creation: 1998
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Handle: RePEc:fip:fedgfe:1998-48

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Related research
Keywords: Rational expectations (Economic theory) ; Financial markets ; Risk;

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Wang, Jiang, 1993. "A Model of Intertemporal Asset Prices under Asymmetric Information," Review of Economic Studies, Blackwell Publishing, vol. 60(2), pages 249-82, April. [Downloadable!] (restricted)
  2. Ilan Goldfajn & Taimur Baig, 1999. "Financial market contagion in the Asian crisis," Textos para discussão 400, Department of Economics PUC-Rio (Brazil). [Downloadable!]
  3. Kenneth A. Froot & Paul G.J. O'Connell & Mark S. Seasholes, 1998. "The Portfolio Flows of International Investors, I," NBER Working Papers 6687, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. King, Mervyn A & Wadhwani, Sushil, 1990. "Transmission of Volatility between Stock Markets," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 3(1), pages 5-33. [Downloadable!] (restricted)
    Other versions:
  5. Ricardo Caballero & Arvind Krishnamurthy, 1999. "Emerging Market Crises: An Asset Markets Perspective," Working papers 99-23, Massachusetts Institute of Technology (MIT), Department of Economics.
    Other versions:
  6. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
  7. Gennotte, Gerard & Leland, Hayne, 1990. "Market Liquidity, Hedging, and Crashes," American Economic Review, American Economic Association, vol. 80(5), pages 999-1021, December. [Downloadable!] (restricted)
    Other versions:
  8. Ilan Goldfajn & Rodrigo O. Valdés, 1997. "Capital Flows and the Twin Crises : The Role of Liquidity," IMF Working Papers 97/87, International Monetary Fund.
  9. Brennan, Michael J & Cao, H Henry, 1997. " International Portfolio Investment Flows," Journal of Finance, American Finance Association, vol. 52(5), pages 1851-80, December. [Downloadable!] (restricted)
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  11. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters?: A chronicle of the Asian crisis," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 537-560, August. [Downloadable!] (restricted)
    Other versions:
  12. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
  13. Michael J. Brennan. and H. Henry Cao., 1997. "International Portfolio Investment Flows," Research Program in Finance Working Papers RPF-271, University of California at Berkeley. [Downloadable!]
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  15. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-57, May. [Downloadable!] (restricted)
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  17. Garry J. Schinasi & T. Todd Smith, 1999. "Portfolio Diversification, Leverage, and Financial Contagion," IMF Working Papers 99/136, International Monetary Fund.
  18. Jorge A. Chan-Lau & Zhaohui Chen, 1998. "Financial Crisis and Credit Crunch as a Result of Inefficient Financial Intermediation—with Reference to the Asian Financial Crisis," International Finance 9804001, EconWPA, revised 24 Apr 1998. [Downloadable!]
  19. Fleming, Jeff & Kirby, Chris & Ostdiek, Barbara, 1998. "Information and volatility linkages in the stock, bond, and money markets1," Journal of Financial Economics, Elsevier, vol. 49(1), pages 111-137, July. [Downloadable!] (restricted)
  20. Caroline van Rijckeghem & Beatrice Weder, 2000. "Spillovers Through Banking Centers - A Panel Data Analysis," IMF Working Papers 00/88, International Monetary Fund.
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Kawai, Masahiro & Newfarmer, Richard & Schmukler, Sergio, 2001. "Crisis and contagion in East Asia : nine lessons," Policy Research Working Paper Series 2610, The World Bank. [Downloadable!]
  2. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  3. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters? A chronicle of the Asian crisis," Policy Research Working Paper Series 2094, The World Bank. [Downloadable!]
    Other versions:
  4. Martin D. D. Evans & Richard K. Lyons, 2003. "Are Different-Currency Assets Imperfect Substitutes?," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  5. Kaufmann, Daniel & Mehrez, Gil & Schmukler, Sergio, 1999. "Predicting currency fluctuations and crises - do resident firms have an informational advantage?," Policy Research Working Paper Series 2259, The World Bank. [Downloadable!]
    Other versions:
  6. Harrison Hong & Jeremy C. Stein, 1999. "Differences of Opinion, Rational Arbitrage and Market Crashes," NBER Working Papers 7376, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Gil Mehrez & Daniel Kaufmann, 2003. "Transparency, Liberalization and Financial Crises," Finance 0308008, EconWPA. [Downloadable!]
  8. Mehrez, Gil & Kaufmann, Daniel, 2000. "Transparency, liberalization, and banking crisis," Policy Research Working Paper Series 2286, The World Bank. [Downloadable!]
  9. Andrea Cipollini & George Kapetanios, 2008. "Forecasting Financial Crises and Contagion in Asia using Dynamic Factor Analysis," Center for Economic Research (RECent) 014, University of Modena and Reggio E., Dept. of Economics. [Downloadable!]
    Other versions:
  10. Das, Sanjiv Ranjan & Uppal, Raman, 2002. "Systemic Risk and International Portfolio Choice," CEPR Discussion Papers 3305, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  11. Tomas Dvorak, 2001. "Gross Capital Flows and Asymmetric Information," Department of Economics Working Papers 189, Department of Economics, Williams College. [Downloadable!]
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