Financial contagion generally refers to the transferable characteristics of the shock of one nation’s asset market to translate to asset prices in a different (but at least somewhat related) independent nation’s financial markets. It is important to realize that this is possible at all because of several different kinds of shocks. Among the most accepted, important, and common of these are information shocks and liquidity shocks.
Information shocks transpire when those investors who are especially well informed, or informed investors, obtain information which they are able to rapidly and effectively utilize in picking out the best possible investment portfolios. Liquidity shocks on the other hand happen as liquidity traders transact in order to attain the necessary inventory for themselves and their client’s immediate liquidity concerns.
Both of these kinds of financial contagion shocks operate in a few different ways, impacting the relevant and affected markets. The chief affected segments are in expectations and portfolio balance components of the changing price. As far as expectations components go, the price change occurs because those investors who are not well informed, or the uninformed investors, catch up their individual asset value and price anticipation to the trades which the informed investors have already executed and had filled. Portfolio balance components in price change quantifies the asset price changes which occur because portfolios are being naturally rebalanced by the uninformed investors as they understand that the prices of the various assets in question do not accurately or adequately reflect the new information which concerns these said assets.
The so-called information effect happens as either liquidity trading or informed investors’ informational advantage reverberates throughout a range of international markets. This can rapidly lead to price changes from a single market reflecting information on assets in various other markets and other countries’ markets. As the informed investors’ knowledge travels to correlated interdependent yet fully independent markets, the uninformed investors from one market see the prices changing in other separate markets and then accordingly rush to place trades in their own national markets.
As liquidity trading reverberates throughout different markets, the price changes of a single market will also impact the assessment of uninformed investors regarding asset prices in other markets. It does not even require that financial markets between different individual sovereign countries be closely or directly linked via the macroeconomic fundamentals for the shocks to effectively transmit from one national market to the other. It may take some time for this to actually happen, but eventually it only requires the indirect sharing of macroeconomic variables in order for such financial contagion transmission to effectively occur.
This goes a long way to explain how financial contagion has so easily transferred between those diverse markets which are even weakly connected in the past, as with Asian markets, European markets, and Latin American national markets. The biggest lesson and warning message from financial contagion analysis proves to be that the inequality of information possessed by informed versus uninformed investors magnifies the effects of international market contagion.