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, and between markets that do not directly share macroeconomic risks.

We review the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset pricing models with mean-variance investors predict that an asset’s risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country’s risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase

For reasons that are not always evident at the time, some financial events, such as the devaluation of a currency or an announcement of default on sovereign debt obligations, trigger an immediate and startling adverse chain reaction among countries within a region and in some cases across regions. This phenomenon, which we dub “fast and furious ” contagion, was manifest after the floatation of the Thai baht on July 2, 1997, as it quickly triggered financial turmoil across east Asia. Indonesia, Korea, Malaysia, and the Philippines were hit the hardest—by December 1997, their currencies had depreciated (on average) by about 75 percent. Similarly, when Russia defaulted on its sovereign bonds on August 18, 1998, the effects were felt not only in several of the former Soviet republics, but also in Hong Kong, Brazil, Mexico, many other emerging markets, and the riskier segments of developed markets. 1 The economic impact of these shocks on the countries unfortunate enough to be affected included declines in equity prices, spikes in the cost of borrowing, scarcity in the availability of international capital, and declines in the value of their currencies and in output.

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Using one of the key property of copulas that they remain invariant under an arbitrary monotonous change of variable, we investigate the null hypothesis that the dependence between financial assets can be modeled by the Gaussian copula. We find that most pairs of currencies and pairs of major stocks are compatible with the Gaussian copula hypothesis, while this hypothesis can be rejected for the dependence between pairs of commodities (metals). Notwithstanding the apparent qualification of the Gaussian copula hypothesis for most of the currencies and the stocks, a non-Gaussian copula, such as the Student’s copula, cannot be rejected if it has sufficiently many “degrees of freedom”. As a consequence, it may be very dangerous to embrace blindly the Gaussian copula hypothesis, especially when the correlation coefficient between the pair of asset is too high as the tail dependence neglected by the Gaussian copula can be as large as, i.e., three out five extreme events which occur in unison are missed.

One of the most feared events in banking is the cry of systemic risk. It matches the fear of a cry of fire in a crowded theater or other gatherings. But unlike "fire, " the term "systemic risk " is less clearly defined. Moreover, unlike fire fighters, who are rarely accused of sparking or spreading rather than extinguishing fires, bank regulators have at times been accused of, albeit unintentionally, contributing to rather than retarding systemic risk. This paper discusses the alternative definitions and sources of systemic risk, reviews briefly the historical evidence of systemic risk in banking, describes how financial markets have traditionally protected themselves from systemic risk, evaluates the regulations adopted by bank regulators to reduce both the probability of systemic risk and the damage caused by it if and when it may occur, and makes recommendations for efficiently curtailing systemic risk in banking. I Systemic Risk Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts. Thus, systemic risk in banking is evidenced by high correlation and clustering of bank failures in a country, a number of countries, or globally. Systemic risk may also

This paper discusses the benefits and risks that financial globalization entails for developing countries. Financial globalization can lead to large benefits, particularly to the development of the financial system. But financial globalization can also come with crises and contagion. The net effect of financial globalization is likely positive in the long run, with risks being more prevalent right after countries liberalize. So far, only some countries, sectors, and firms have taken advantage of globalization. As financial systems turn global, governments lose policy instruments, so there is an increasing scope for some form of international financial policy cooperation.

Information transferred between Þnancial markets can be impor-tant during a Þnancial crisis. Using a latent factor model of returns we consider spillovers and contagion between currency and equity markets for a panel of countries in the East Asian cirsis of 1997-98. Financial returns are modelled as a linear combination of unobserved factors rep-resenting: shocks unique to the market and country, country-speciÞc shocks, common market shocks, world shocks, spillovers between mar-kets and contagion between markets. Using a deÞnition adapted from Masson (1998,1999), contagion is modelled as the effects of the resid-ual in one market on the other, after controlling for all other forms of shock. The results show that spillovers and contagion from currency markets accounted for the vast majority of equity market volatility. With the exception of Indonesia, contagion from equity markets had little effect on currency markets. Indonesian returns show strong evi-dence of contagion effects in both equity and currency markets.

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Many countries have experienced serious banking and/or currency (exchange rate or balance of payments) problems in recent years with high costs to their own countries and others. A study by the International Monetary Fund (IMF) reported that more than 130 of the IMF’s 180-plus member countries had experienced serious banking problems between 1980 and 1995 and this was even before the recent East Asian banking crises (Lindgren, Garcia, and Saal 1996). A map of countries experiencing banking crises is shown in Figure 1. The authors ’ define serious problems to include banking crises that involve bank runs, collapses of financial firms, or massive government intervention, as well as less damaging but extensive unsoundness of institutions. With the exception of the U.K., the Benelux countries and Switzerland, most of the countries that avoided bank problems had no or nearly no banking systems. Currency crises were even more frequent than banking crises. They are typically