Financial Contagion - It is has not gone away

 

 

We can think of the 21st century as the age of financial contagion. Perhaps we have not seen more contagion in the 21st century, but it seems that they when they do occur, these contagion events have been more impactful over the last two decades. Information moves more swiftly through markets. Investors react more quickly to these new events which change expectations. There are more short-term agents in the marketplace. All these factors contribute to the large potential contagion events in currencies, the stock market, and banking. With contagion comes crises, there are spillover effects that create adverse markets moves. 

There are several definitions for a contagion event. Contagion is a significant increase in the probability of a crisis in other markets, when there is a crisis in one market. Put differently, a contagion is an increase in the volatility of associated markets or spillover from an increase in volatility in one market. A contagion will lead to higher cross-market correlations, co-movements, or an adverse price move when one market is hit with a market shock. A contagion occurs when the transmission channel changes after a shock in one market. 

The cause of a contagion is based on financial interdependence either through similarity in information shocks or portfolio effects. If there is a shock with one market, there may be a change in the probability of a down moves in other markets which may have similarity with the shocked market. The shock will be based on new information that shifts expectations. This new information will change the expectations for a broader set of markets and lead to a more general sell-off. Along with the expectational channel, there is also a leverage and portfolio effect. if there is a decline in one market which increases portfolio volatility, there will be a corresponding in position risk as an investor delevers, or adjusts allocations. There will be an income and substitution effect. The price decline in one asset will lead to a position adjustment as part of risk management. The portfolio effect of higher volatility may lead to closing multiple positions. A good review article is "A Primer on Financial Contagion"