NCPA - National Center for Policy Analysis

Financial Epidemics

January 2, 2002

Like epidemics, financial crises tend to spread. Witness the 1997 Asian crisis, which quickly engulfed South Africa, Eastern Europe and even Brazil. Many economists have argued that financial institutions sometimes panic, disregard fundamentals and thus spread a crisis even to countries with strong fundamentals. Individual investors, too, can contribute to a crisis by selling mutual funds, forcing fund managers to sell when the fundamentals do not warrant that action.

A recent study considered the contagion-trading phenomenon by studying the behavior of U.S. international mutual funds focused in emerging markets. Among the author's findings:

  • During crises, emerging market funds engage in "momentum trading," selling stocks that recently declined and buying recent winners.
  • Momentum trading is stronger during a financial crisis, and fund investors incline to it more than do fund managers.
  • Lagged momentum trading (buying past winners and selling past losers) is stronger during non-crisis periods and is stronger for fund managers than fund investors.
  • Funds engage in contagion trading, i.e., systematically selling assets from one country when asset prices begin to fall in another, although this is primarily due to panicky investor sales, not fund manager activity.

Source: Lucille Maistros, "How Financial Crises Spread," NBER Digest, January 2001; based on Graciela Kaminsky, Richard Lyons and Sergio Schmukler, "Managers, Investors, and Crisis: Mutual Fund Strategies in Emerging Markets," NBER Working Paper No. 7855, August 2000, National Bureau of Economic Research.

For NBER Digest article


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