We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, as well as between markets that do not directly share macroeconomic risks. A SPATE OF RECENT FINANCIAL CRISES-theMexican crisis of 1995, the Asian crisis of 1997 to 1998, the default of the Russian government in August 1998, the sharp depreciation of the real in Brazil in 1999-have been accompanied by episodes of financial markets contagion in which many countries have experienced increases in the volatility and comovement of their financial asset markets on a day-to-day basis. The pattern of contagion has been uneven across both time and countries-with increased volatility and comovement occurring principally during times of financial and exchange rate crises-and with some countries, particularly those with emerging financial markets, having experienced the bulk of the contagion, while countries with more developed markets have remained relatively unscathed.Although heightened financial market volatility is to be expected within countries experiencing financial and exchange rate crises, the pattern of comovement across countries is not easily explained. Some of the increased comovement among countries that compete through trade or share close economic links can be rationalized on the basis of macroeconomic theory, but these theories are less persuasive in accounting for the increased comove-* International Monetary Fund and the Board of Governors of the Federal Reserve System, respectively. The authors thank Sriram Rajan for research assistance, and Mico Loretan for useful comments and extensive guidance in preparing this document. Comments from audiences and discussants at the Federal Reserve Board, the Bank of Japan, the Federal ReserveThe Journal of Finance ment among the financial markets of weakly linked countries such as those of South East Asia and Latin America. An alternative reason for the increased comovement is that financial markets are responding to the same public news events. However, even accounting for the release of economic news and other information, much of the increased volatility and comovement across countries remains unexplained (Baig and Goldfajn (1999), Kaminsky and Schmukler (1999), Connolly and Wang (2000)).In this paper, we present a rational expectations model of financial markets. The model is designed to describe asset price movements over short periods of time-such as a day or a week-during which macroeconomic conditions can be taken as given. Using the model, ...

We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, and between markets that do not directly share macroeconomic risks.

We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, and between markets that do not directly share macroeconomic risks.

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We identify current challenges for creating stable, yet efficient financial systems using lessons from recent and past crises. Reforms need to start from three tenets: adopting a system-wide perspective explicitly aimed at addressing market failures; understanding and incorporating into regulations agents' incentives so as to align them better with societies' goals; and acknowledging that risks of crises will always remain, in part due to (unknown) unknowns-be they tipping points, fault lines, or spillovers. Corresponding to these three tenets, specific areas for further reforms are identified. Policy makers need to resist, however, fine-tuning regulations: a "do not harm" approach is often preferable. And as risks will remain, crisis management needs to be made an integral part of system design, not relegated to improvisation after the fact.