A Rational Expectations Model of Financial Contagion

By L. Kodres, M. Pritsker. 2002

1,142 citations recorded by the source corpus.

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.

Subfields: Finance

View Paper: https://www.semanticscholar.org/paper/d2ec2af54a4ed2baf04b410d60feacf0824139c4

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Citations in the corpus

No contagion, only globalization and flight to quality (2012, background): “Some authors claim that contagion is driven by fundamentals (Erdorf and Heinrichs, 2011; Kodres and Pritsker, 2002), while others view contagion as created by over-reactions (Broner et al., 2006; Goldstein and Pauzner, 2004).”
Contagion in financial networks (2010, background): “…but not to each other, may also be susceptible to contagion.3 2Other strands of the literature on nancial contagion have focussed on the role of liquidity constraints (Kodres and Pritsker, 2002), information asymmetries (Calvo and Mendoza, 2000), and wealth constraints (Kyle and Xiong, 2001).”
Contagion: How it spreads and How it can be stopped * (2000, background): “One of the implications of the liquidity and incentive problems might be that countries whose financial assets are widely traded in global markets and whose domestic financial markets are more liquid, are more vulnerable to financial contagion (Calvo and Mendoza 1998, and Kodres and Pritsker 1998).”
Is Credit Event Risk Priced? Modeling Contagion Via the Updating of Beliefs (2010, neutral): “…Gennotte (1986) • Regime Switching – Hamilton (1989), Veronesi (2000), Guo, Miao, and Morellec (2002) • Contagion (theoretical) – King and Wadhwani (1990), Kodres and Pritsker (2002) • Contagion (empirical) – Lang and Stulz (1992), Bae, Karolyi and Stulz (2000) • Default Risk – Jarrow, Lando…”
Financial Spillovers to Emerging Markets During the Global Financial Crisis (2009, neutral): “The identification of channels of shock transmission across countries is, for instance, discussed in Dungey, Fry, Gonzalez-Hermosillo and Martin (2005), Dornbusch, Park and Claessens (2000) and Pericoli and Sbracia (2003). Beirne, Caporale, Schulze-Ghattas and Spagnolo (2008) examine volatility spil”
Imperfect Competition, Information Heterogeneity, and Financial Contagion (2007, positive): “Along those lines, Fleming, Kirby, and Ostdiek (1998) and Kodres and Pritsker (2002) argued that the portfolio rebalancing activity of privately informed, price-taking investors—driven by risk aversion—may mislead the updating process of other, uninformed investors, thus eventually inducing…”
Global Crises and Equity Market Contagion (2012, positive): “Kodres and Pritsker (2002) develop a model where portfolio rebalancing creates “rational contagion,” the severity of which depends on shared macro-risk factors and the information asymmetry in each market. Kyle and Xiong (2001) focus on losses by arbitragers which may lead to liquidations in several”
Information Asymmetry, Diversification, and Cost of Capital (2007, background): “Imposing the market clearing condition that the total demand from the informed and the uninformed investors equals the supply, we obtain the following equation: x = M ( µ A Σ−1ν|s(ν̄ + Φss−Rfp) + 1− µ A Σ−1ν|θ(ν̄ + Φθθ −Rfp) ) , where µ is the proportion of informed investors.”
Contagion in Emerging Markets: When Wall Street is a carrier (2004, background): “Actually, price signals could aggravate the effects on margin calls (as shown in Genotte and Leland (1990) and, more recently, Kodres and Pritsker (1998)).”
News Spillovers in the Sovereign Debt Market (2003, positive): “Examples of theoretical models include Allen and Gale (2000), Kodres and Pritsker (2002), and Kyle and Xiong (2001).”
Does the carbon market help or hurt the stock price of electricity companies? Further evidence from the European context (2016, background): “…correlation (DCC) specification is considered significant as some studies have already evidenced that conditional correlations between different financial variables are not constant (Ewing, Malik, & Ozfidan, 2002; Fleming, Kirby, & Ostdiek, 1998; Hassan & Malik, 2007; Kodres & Pritsker, 2002).”