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Financial Market Contagion

Financial markets around the world are getting more integrated. In this integrated market system any shock to the system in a single market can quickly move to other markets and thus creating a contagion. The transmission channels of these shocks are the financial, real, and political linkages between the countries. In empirical studies of contagion events, the fundamental linkages among economies alone cannot explain the strength of the shock spillovers from one market to another. Behavioral finance theories offer an alternate explanation for this anomaly. The shock spillovers can be attributed to irrational behavior of investors and herding mentality among them. Several ways are available for studying the transmission of shocks. In the chapter three such methods are discussed: the variance ratio model, dynamic conditional correlation model, and cointegration model. This chapter concludes with a brief overview of some of the recent contagion events.