Financial Contagion and Attention Allocation

Working Papers from University of Toronto, Department of Economics

Abstract: This paper explains financial contagion between two independent stock markets by fluctuations in international investors' attention allocation. I model the process of attention allocation that underlies portfolio investment in international markets using rationally inattentive agents. Investors optimally allocate more attention to a region hit by a financial crisis, to the detriment of other markets. The resulting endogenous increase in uncertainty causes the risk premium on all risky assets to rise. Hence, stock prices around the world collapse and there is a flight to quality. I show that the degree of (non)anticipation of a crisis is crucial for the existence of contagion. Using Financial Times coverage as a proxy for attention allocation, I find strong support for the model's predictions.

Keywords: Financial Crises; Rational Inattention; Portfolio Choice (search for similar items in EconPapers)
JEL-codes: F30 D83 G11 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin and nep-fmk
Date: Written 2006-09-12
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Working Paper: Financial Contagion and Attention Allocation (2006)
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