A Rational Expectations Model of Financial Contagion

Posted: 28 Dec 2003

See all articles by Laura E. Kodres

Laura E. Kodres

International Monetary Fund (IMF) - Research Department

Matt Pritsker

Federal Reserve Bank of Boston

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Abstract

We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, as well as between markets that do not directly share macroeconomic risks.

Suggested Citation

Kodres, Laura E. and Pritsker, Matthew G., A Rational Expectations Model of Financial Contagion. Available at SSRN: https://ssrn.com/abstract=309180

Laura E. Kodres (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

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Matthew G. Pritsker

Federal Reserve Bank of Boston ( email )

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