Federal Reserve Bank Of New York: A Study On Contagion Theory

Includes: DIA, IWM, QQQ, SPY
by: Celan Bryant

Recently a staff FRBNY paper was published entitled Informational Contagion in the Laboratory.

The authors set up an experiment with two markets; the two markets had highly correlated fundamentals.

The study found that information contagion pushes up asset prices regardless of the underlying fundamentals.

Unlike our last review of a staff FRBNY paper, a study of what drives retail investment behavior, this paper is about what drives institutional investment behavior, at least one segment of it.

The paper, entitled Informational Contagion in the Laboratory by Marco Cipriani, Antonio Guarino, Giovanni Guazzarotti, Federico Tagliati, and Sven Fischer, looks at information contagion under a scientific lens by creating a lab experiment out of the seminal paper Transmission of Volatility between Stock Markets by King and Wadhwani (1990), which showed that informational leaks across financial markets can generate financial contagion.

The authors set up an experiment with two markets. The markets have highly correlated fundamentals. Traders in the first market receive private information and traders in the secondary market (read: market that opens after the first market) react, and in some cases over-react, to movements in the first market. "As a result", the paper says, "We observe financial contagion in the laboratory: Indeed, the correlation between asset prices is very close to that predicted by the theory." In other words, traders use the movement of other markets to validate the information they're receiving. They use the co-movement of primary markets to determine what information, public or private, is relevant in the secondary market which pushes up asset prices regardless of the underlying fundamentals, ergo "Information Contagion" or "Rational Expectations Equilibrium" in the original study by King and Wadhwani.

So what? This may seem like a pointless experiment, after-all, how else does contagion get started but from the passing on of information? Well, contagion has also been shown to arise from liquidity shocks as "agents hit by a liquidity shock in one market, liquidate their position across markets in order to meet a margin call" Calvo (1999) Yuan (2005). Kyle and Xiong (2001) were able to prove that financial contagion stemmed from wealth effects while Fostel and Geanakoplos (2008) suggested "contagion arises as a result of the interplay between market incompleteness, agents' heterogeneity, and margin requirements," which sounds like another way of saying "lack of liquidity".

What practical use does this study have? While the Fed can, and is working on, putting measures in place to prevent liquidity runs, i.e., overnight and term repo agreements, there is little it can do about information contagion, which may be why it's being studied. The good news for investors, however, is that because the co-movement is driven by prices rather than fundamentals, market forces should prevail.

King, M. and Wadhwani, S. (1990) Transmission of Volatility between Stock Markets, Review of Financial Studies, 3, 5-33.

Calvo, G. (1999) Contagion in Emerging Markets: When Wall Street is a Carrier, mimeo, University of Maryland

Kyle, A. and Xiong, W. (2001) Contagion as a Wealth Effect, Journal of Finance, 56, 1401-1440

Fostel, A. and J. Geanakoplos (2008) Leverage Cycles and The Anxious Economy, American Economic Review, 98, 1211-1244.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.