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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page A Rational Expectations Model of Financial Contagion
Laura E. Kodres and Matthew Pritsker

Abstract: We develop a multiple rational expectations model of securities prices to explain the determinants of financial market contagion. Although the model allows contagion through several channels, our primary focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to macroeconomic risks which are shared across markets. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, and between markets that do not directly share macroeconomic risks.

Keywords: Rational expectations, contagion, emerging markets

Full paper (477 KB PDF)

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