Financial Contagion

Financial Contagion refers to movement of prices from one market or country which occurs as a result of a shock from another market or country. Robert Kolb refers to financial contagion as a financial distress that arises from changes that affect certain financial institutions and spread to others. According to Kolb, defining the term financial contagion depends on conceptual differences such as a change in probabilities of a crisis or a change in volatility. Sharma posits that it may also be further described as a profound change in the global economy which may result from an increasing global imbalance.

What is the mechanism of transmitting financial contagion between countries? In their article, Racickas and Vasiliauskaite argue that the mechanism through which the contagion spreads, from one state to the other state is a complicated process and it differs depending on the crisis at hand. According to the authors, to understand what financial contagion is all about, it is critical to determine the individual channels where the contagion occurs. In the mechanism, the key economic units include the real sectors, market participants such as the non-financial banks, and the banks. These are the linkages derive the channels of financial contagion. In the market, there exist different types of shock. For example, when investors in the market receive unexpected information which they use when selecting their optima portfolios, it may fall under the category of information shock. Liquidity shock is another type of shock which occurs when liquidity traders are trading with an aim of meeting their individual needs for liquidity. Based on the information given, it is evident that each shock in the market has way in which it affects the market and its portfolio balance component which is in the price market. Price changes in a market usually reflect that there are a number of uniformed investors with the right information who want to change their expectations for the asset values. It is done after most of the investors make a trade based on the information which they receive.

What are the effects of financial contagion? One of the main causes of changes in financial regulation comes from financial contagion on a domestic and international level. The effect and severity of financial contagion is highly dependent on the kind of contagion that involved in a market. All countries do not necessarily transit shocks to other countries through direct links from the macroeconomic fundamentals. Therefore, it is only a regression or sensitive analysis that is likely to indicate the countries that are most likely to transmit or get affected by different types of financial contagion.