I am trying to read the never ending pages from our curriculum for this section (I should have simply ordered Schweser!) Anyway… I don’t get any summary from the long winding explanations… Contagion - markets mover closely during period of crisis. They talk about currency markets and equity markets. One other point I gathered was contagion is one step more than correlation… Can someone please add more ‘must know’ points here ?
Contagion Country tries to maintain a peg while engaging in lax fiscal and monetary policy = Bad
Country tries to maintain a peg while engaging in lax fiscal and monetary policy then blames hedge funds for debacle = worse
contagion during market crisis occurs because market participants act the same way (herding bias or prudent bias - no wanting to make extreme predictions)…so correlations between developing and developed markets increase, minimizing the effects of emerging market diversification.
I like the clarity in your explanation… Thanks strikershank…
Actually empirical evidence suggests that there’s very little if any contagion effect on equity markets. The same, however, cannot be said about currency valuations which is what I think you guys are referring to above?
what reading is this?
i just relooked at what the CFAI said and it seems PJ’s right (essentially). The CFAI suggests that there is a strong currency contagion but that equity contagion is inconclusive. i wroet my posts above detailing answers i’ve seen written either in CFAI questions or schweser…so i’ll stick with that on the exam i suppose (albeit with less confidence now).
PJStyles and Strikershank - You are right. Contagion in currency markets is more prominent than equity markets. Currency Crisis in one country can spread to other countries for both rational and irrational reasons. Irrational - Speculative attack. Rational -reduced imports etc.
additionally, in Emergiing Markets currencies are usually positively correlated with equity markets…
That kills me… You would think that if currency markets suffer from contagion and equity markets are correlated with currency markets, they too would suffer from contagion.
remember though that currency risk is about 1/2 that of stock risk, so if FX suffers from contagion, the equity markets would (if all else holds i guess) suffer from about 1/2 the amount of contagion.