Banking and Finance - Assignment Example

Banking and finance: contagion Author’s name Institutional affiliation Banking and finance: Contagion Introduction Financial contagion basically revolves around the likelihood that major economic changes will in one way or the other spread to other countries (Investopedia, 2015). Additionally, this spread may be an economic crises or an economic boom throughout a geographic region. Moreover, contagion has established itself as an important concept because economies have become intereloa5ted within a certain geographical area due to the growing global economy (Business dictionary, 2015). For example, the 1997 Asian contagion that emanated in Thailand and eventually spread to the Southeast Asian countries and finally to the Latin America. Therefore, financial contagion can be termed as a financial shock to a country asset that eventually result in a shift in assets prices in the neighboring countries’ financial market (Investopedia, 2015). Examining the causes and effects of financial contagion is important in comprehending the some of the financial crisis in Asia as well as Latin America so as to stipulate steps of curbing such situations. Causes and effects of financial contagion In a market situation, there exist distinctive types of assets shocks. Information shocks are said to occur whenever those investors in the know attain information and data that they use to their advantage in obtaining their optimal portfolios (Kolb, 2011). Additionally, liquidity shocks occur whenever those trading in liquidity do so in order to meet their liquidity needs. Furthermore, each and every shock has its unique way of affecting the financial and asset market in terms of the portfolio balance and expectations components of assets price change. By definition, the expectation component involves a scenario when uniformed investors adjust their asset values expectations based on the new data and information they have attained (Kristin & Stijn, 2006). On the other hand, the portfolio balance asset component reflects on the shifts in asset prices as a result of portfolio rebalancing by informed investors due to the belief that the asset prices shifts do not clearly indicate the information (Kolb, 2011). In simple terms, a shift in the asset management in one market may hamper or enhance the asset prices in another market according to the Slutsky equation and the substitution effect as a result of data and information presented. It is universally acknowledged that, an information effect in terms of investment or liquidity information can cause a financial contagion whenever the liquidity or investors information correlates with other nations markets making it possible to reflect the asset prices in their respective markets (Kolb, 2011). Additionally, when a financial contagion occurs in one country, those uninformed investors view this shifts as a change associated with asset values in the bordering markets. Furthermore, assets correlation across markets as a result of liquidity trading make those investors that lack information unsure of the real cause of the asset price changes such that they are not sure if it is due to investors information or basically due to noise(Kristin & Stijn, 2006). Moreover, financial contagion may occur whenever the shocks that have happened in one market are passed onto the next market whenever investors readjust their optimal portfolios in the process of reacting to the shock. In the process, they transmit the shock abroad causing a financial contagion. Information and portfolio rebalancing clearly indicates countries do not necessarily have to be interlinked directly by macroeconomic basics in order to cross interchange shocks. By so saying it means that, all that is needed in order to pass on shocks is the indirect sharing of macroeconomic variables through other nations. Therefore, this clearly explains the causes of financial contagion in those countries that are weakly interconnected such as Asia and the Latin America. Moreover, the implication of contagion on the financial assets is greater on those countries ‘markets that have greater information asymmetries. Furthermore, those nations that possess high asymmetric information experience greater shifts and fluctuations in financial assets prices as compared to those with low asymmetric information (Kristin & Stijn, 2006). In other words, developing markets possess a higher level of asymmetric information than do already develop markets. It is therefore clear why the emerging markets are the worst hit when it comes to financial contagion than developed markets due to the unstable conditions in the emerging markets. It is often known that, those countries that are unstable in terms of finance are also politically unstable. Owing to these, those countries that have less information asymmetry remain relatively untouched by the financial contagion but they merely act as conduits for shock transmission within markets (Ozkan & Unsal 2012).. It is therefore ironic that reducing information in the developed markets worsens the implications of contagion in the emerging markets where in most cases information asymmetric is clearly persistent. In most cases, when individuals consider financial markets, they tend to focus mainly on resource deployments within a specified geographical space and time. Additionally, people tend to forget that financial markets in their effort to provide efficiency can cause unintended side implications that may cause economic instabilities (Ozkan & Unsal 2012). Furthermore, through the shock transmission across markets, financial contagion results in instabilities in the nation’s economy which hinders their economic development as a result of contagion-induced instability (Kolb, 2011). Those nations which have developed markets in most cases view financial contagion issue as an emerging market condition that is a non-issue to developed markets. Therefore, this is clearly a mindset that was born as a result of the implications that financial contagion has on developing economies and the minimal effect it causes on the already developed markets (Kristin & Stijn, 2006). For example, the financial crisis in China, Brazil Asia and Mexico is always studied not considering the fact that already developed markets always provides a channel for these financial contagion situations. It is universally acknowledged that, the lack of information asymmetries often considered as beneficial may also serve as a negative externality in the developing markets. Additionally, financial contagion is a significant witness to inefficiencies in the market. Furthermore, it is not possible for any investor to gain above average returns whenever he employs information relating to financial contagion (Lewinsohn & Bild, 2010). In other words, it is not possible to use one nation’s asset prices to evaluate the other nation’s asset prices hence making it impossible to consistently gain net revenues. The extent of financial contagion risk and how to manage it. A clear comprehension of financial contagion and its evaluation is a big step in its right. Therefore, reducing instability in emerging nations would help greatly in improving their economic growth and development. One way of curbing instability in developing countries is by working on ways of curbing their financial markets instability (Jonathan, 2013). By so saying, by establishing the major cause of financial instability in the emerging nation, which in this case is financial contagion according to the analysis of the previous crisis, it will be possible to make a step forward in managing financial instability in developing nations. In other words, reducing financial contagion will make it possible to increase the stability of developing markets hence fostering stability in emerging countries (Kolb, 2011). One way of curbing financial contagion is limiting information asymmetries. As we have clearly seen that the more the information asymmetries, the higher the financial contagion implications. In simple terms, if an effort is made in availing financial information to all available investors, then issues relating to financial asymmetries could be reduced (Ötker et al.,2009). By so doing, it will simultaneously also curb the severity and probability of shock transmissions between markets. Besides, curbing the information asymmetries issues, the financial contagion implications in emerging markets could also be reduced if the channels of contagion could be eliminated(Kristin & Stijn, 2006). It is therefore clear that, if a way is postulated of reducing cross-rebalancing of portfolios in emerging markets and concentrating only in developed markets, shocks therefore could not be passed onto those emerging markets that are not in a better position to deal with it. Most of the risks involved with financial contagion serve to move the developing nation’s markets away from fundamental value efficiency (Kolb, 2011). Therefore, curbing the implications of financial contagion is one of the most fundamental steps towards economic improvement. By so saying, it means that, if the asset prices reflect basic value efficiency of the market then the financial contagion will stop causing instability in the market. In other words, the closer the fundamental market efficiency becomes to a nation, then the lesser the effects of financial contagion (Ozkan & Unsal, 2012). Conclusion Examining the causes and effects of financial contagion is important in comprehending the some of the financial crisis in Asia as well as Latin America so as to stipulate steps of curbing such situations. Additionally, Information and portfolio rebalancing clearly indicates countries do not necessarily have to be interlinked directly by macroeconomic basics in order to cross interchange shocks (Claessens & Forbes, 2001). By so saying it means that, an information effect in terms of investment or liquidity information can cause a financial contagion whenever the liquidity or investors information correlates with other nations markets making it possible to reflect the asset prices in their respective markets References Business Dictionary, (2015). Financial contagion. Retrieved from: http://www.businessdictionary.com/definition/financial-contagion.html Claessens, S., & Forbes, K. J. (2001). International Financial Contagion. Boston, MA: Springer US. Investopedia, (2015). Contagion. Retrieved from: http://www.investopedia.com/terms/c/contagion.asp Jonathan Lhost, (2013).The cause, effects, and implications of financial contagion. Retrieved from: http://economics.about.com/cs/moffattentries/a/contagion_4.htm Kolb, R. W. (2011). Financial contagion: The viral threat to the wealth of nations. Hoboken, N.J: Wiley. Kristin Forbes, Stijn Claessens, (2006). International financial contagion. Retrieved from: http://web.mit.edu/kjforbes/www/Papers/ContagionBook-Overview.pdf Lewinsohn, R., & Bild, P. (2010). Financial contagion: Lessons from the great depression. Luzern?: Richard Lewinsohn-Morus Stiftung. Ötker, I., Driessen, K., Árvai, Z., & Ötker, I. (2009). Regional Financial Interlinkages and Financial Contagion within Europe. Washington, D.C: International Monetary Fund. Ozkan, F. G., & Unsal, D. F. (2012). Global Financial Crisis, Financial Contagion, and Emerging Markets. Washington: International Monetary Fund. Tressel, T. (2010). Financial Contagion through Bank Deleveraging: Stylized Facts and Simulations Applied to the Financial Crisis. Washington, DC: International monetary fund (IMF. Read More