The paper 'Banking and Finance' is a wonderful example of a Finance and Accounting Assignment. 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 crisis 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 Latin America.
Therefore, financial contagion can be termed as a financial shock to a country asset that eventually results in a shift in asset prices in the neighboring countries’ financial market (Investopedia, 2015). Examining the causes and effects of financial contagion is important in comprehending some of the financial crises 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 asset price change. By definition, the expectation component involves a scenario when uninformed 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 price 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 shift 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.
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