A Rational Expectations Model of Financial Contagion

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.

JEL Classification: F36, G14, G15, D82, D84