Fluctuating Attention and Financial Contagion
55 Pages Posted: 18 Jan 2015 Last revised: 30 Jul 2018
Date Written: June 10, 2018
Financial contagion occurs when return and volatility transmit between fundamentally unrelated sectors. Our equilibrium model shows that contagion arises because investors pay fluctuating attention to news. As a negative shock hits one sector, investors pay more attention to it. This raises the volatility of equilibrium discount rates resulting in simultaneous spikes in cross-sector correlations and volatilities. We test the economic mechanism of the model on fundamentally unrelated U.S. industries, which are identified using their customer-supplier relationships. Consistent with the model's predictions, empirical evidence shows that fluctuating attention generates return and volatility spillovers between fundamentally unrelated industries.
Keywords: Asset Pricing; General Equilibrium; Learning; Attention; Contagion
JEL Classification: G12; G13; G14
Suggested Citation: Suggested Citation