Keywords: Rational expectations, contagion, emerging markets
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.
Full paper (477 KB PDF)
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