How Does a Financial Contagion in the Stock Market Affect Us?

Like a physical disease, contagious financial panics hurt not only those directly affected but an entire system. Financial contagion in the stock market is when an economic crisis such as a crash, spreads from one market or area to another. This can happen at both the domestic and international levels. The Global Financial Crisis provided us with front row seats to the resulting financial contagion in the stock market.

What Is Financial Contagion in the Stock Market?

Financial Contagion in the Stock Market

When a crisis in one country’s stock market causes a crisis in another country’s stock market, this can be thought of as financial market contagion.

Let’s explore this further. Consider the scenario in which a crash in one financial market reduces the wealth of traders who trade in other markets. To offset their losses, they look to rebalance their portfolios by selling off assets in different markets.

This triggers a domino effect causing a crash there, too, even if the two markets are unrelated. When you’re not expecting this to happen, it can be traumatizing to you to see your trades go red.

At that moment, you wonder whether to hold or panic sell. Bear markets and corrections often cause panic selling by traders who don’t understand how to spot either. But a financial contagion is different because another market is causing the decline. When it comes to that, you’re probably looking for some CBD oil to both invest in and take.

5 Second Takeaway

  • Financial contagion happens when an economic crisis such as a crash spreads from one market or area.
  • It can happen at both the domestic and international levels.
  • Many feel financial contagions are due to the interdependence of our global markets.
  • There is evidence of cross-border contagion in the currency and equity markets.

Four Main Criteria To Identify Financial Contagion

  1.  A decline in an asset price leads to declines in other asset prices.
  2. The relationships between asset price declines are different from those observed in “normal” times.
  3.  Economic fundamentals are unable to explain the relationships.
  4.  There are negative extremes, such as market crashes, so that they correspond to crises.

What Causes Financial Contagion?

If we want to prevent a financial contagion, we need to know what causes it. Macroeconomics is a big factor because it happens on a large scale. It’s find of like an earthquake. When it’s a 10 on the Richter scale, you can feel the effects of it a state or town away. So when a macroeconomic shock occurs, we see it affect different markets.

Real-Life Examples of Financial Contagions/Economic Tsunami

Financial Contagion

In case you didn’t notice, we just lived through financial contagion. With COVID-19 sweeping the globe, the pandemic has induced a different and more severe version of the contagion phenomenon.

COVID-19 wreaked havoc on six other stock markets, leading to structural breaks in the volatility of stock indexes. And the first to break?

The Chinese stock market on January 30th, 2020. It took about three weeks for the economic tsunami to hit the rest of the global markets. Around February 19-21, 2020, to be exact. 

It was a scary time for a lot of people. Jobs shut down, school closed, and we were told to stay home. That of course had an effect on the economy. If you worked in a restaurant or bar, you’re probably still feeling the effects.

A Look Into The Past

One doesn’t have to look too far back to see real-life examples of financial contagions. Case in point, the devaluation and collapse of the Thai baht in 1997. This watershed moment opened the floodgates, which saw tides quickly sweep away East and Southeast Asia’s financial markets.

With the devaluation of the baht, many regional markets faced enormous pressure. As the tides grew in a tsunami-like fashion, stock market turmoil spread throughout the region. We saw the unravelling of Malaysia and Indonesia’s currencies.

Ultimately the wave hit Korea, causing the collapse of their won. Shockingly, impacts were felt in the markets of Eastern Europe and Latin America. All of this goes to show the capacity of contagions to spread quickly beyond regional markets.

How Can We Fight the Financial Crisis?

Most of us have probably suffered in one way or another financially in 2020. Everyone being home caused a spike in retail trading. Retail traders have changed the game in some way. Just look at GameStop. But how does that fight a financial crisis if you haven’t learned how to properly trade?

Trading meme stocks isn’t going to help you out in any way, shape, or form financially unless you know technical analysis and risk management. Emotional trading helps contribute to a financial contagion. So learn how to hedge your positions. Put together a trading plan and stick to it.

Don’t buy at a top. Buy low, sell high sounds simple. Until you’re in the moment. FOMO trading is the enemy of everyone. Use wisdom when you trade and you’re better prepared to fight a financial crisis. And learn how to trade a bearish market. There is money to be made in a bear market.

Interpreting Financial Contagion

Financial Contagion

East Asia’s economic shocks were not followed by a normal cyclical downturn but what some describe as “runs” on financial systems and currencies. These runs reflected a classic financial panic that did not reflect poor economic policies or institutional arrangements.

As is well known, it can happen when one large bank quickly unloads most of its assets. Once again, a domino effect can quickly happen, and confidence in other large banks drops accordingly. 

Alternatively, if everyone  decided to withdraw their funds at the same time, the bank would not have enough liquid cash to meet it’s debt obligations.

Ultimately, this would threaten the banks viability as they wouldn’t be able to meet their financial obligations.

Causes of Financial Contagion in the Stock Market

What is the driving force behind shock waves felt in the market’s thousand’s of kilometer’s away from each other? Is it fundamentals driven, or cases of irrational, herd mentality displayed by panic-stricken investors? Alternatively, could the reaction of the markets simply be explained away by their historically close relationships? 

As you can see above, there are many trains of thought as to why financial contagions happen. For starters, the lack of risk management. In particular, the use and extension of credit. In some cases, everyone was extended credit regardless of their credit score.

Second, the financial middlemen were not expected to bear the full costs of failure. Thus, reducing their incentive to manage risk effectively. We just need to look in our own backyard for that in the housing crisis of 2008.

Lessons To Take Away

The results of the economic impact of financial contagions in the stock market should be valuable for investors. The importance of diversifying your portfolio and managing financial risk cannot be overstated as fortune’s can be wiped out overnight. It’s important not to put all your eggs in one basket.