Financial Contagion and Attention Allocation

Abstract:     
This paper explains financial contagion between two independent stock markets by fluctuations in international investors' attention allocation. I model the process of attention allocation that underlies portfolio investment in international markets using rationally inattentive agents. Investors optimally allocate more attention to a region hit by a financial crisis, to the detriment of other markets. The resulting endogenous increase in uncertainty causes a reduction in the capacity of bearing risks by international investors that induces them to liquidate their positions in all risky assets. Hence, there is an increase in price volatility and a collapse in stock prices around the world. I also show that the degree of (non)anticipation of a crisis is crucial for the existence of contagion.

Number of Pages in PDF File: 39

Keywords: Rational Inattention, Financial Crisis, Asset Pricing, Portfolio Choice

JEL Classification: F30, D82, G12, G11

working papers series