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.

Many large financial institutions compute the Value-at-Risk (VaR) of their trading portfolios using historical simulation based methods, but the methodsÕ properties are not well understood. This paper theoretically and empirically examines the historical simulation method, a variant of historical simulation introduced by Boudoukh et al. [Boudoukh, J., Richardson, M., Whitelaw, R., 1998. The best of both worlds, Risk 11(May) 64-67] (BRW), and the filtered historical simulation method (FHS) of Barone-Adesi et al. ]. The historical simulation and BRW methods are both under-responsive to changes in conditional risk; and respond to changes in risk in an asymmetric fashion: measured risk increases when the portfolio experiences large losses, but not when it earns large gains. The FHS method is promising, but its risk estimates are variable in small samples, and its assumption that correlations are constant is violated in large samples. Additional refinements are needed to account for time-varying correlations; and to choose the appropriate length of the historical sample period.

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.