We develop a multiple rational expectations model of securities
prices to explain the determinants of financial market contagion.
Although the model allows contagion through several channels, our
primary 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
macroeconomic risks which are shared across markets. 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, and between markets that
do not directly share macroeconomic risks.
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