Contagion as a wealth effect

Financial contagion is described as a wealth effect in a continuous-time mo del with two risky assets and three types of traders. Noise traders trade r andomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility t rade optimally in both markets. Asset price dynamics are endogenously deter mined (numerically) as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both marke ts. This creates contagion, in that returns become more volatile and more c orrelated. Contagion reduces benefits from portfolio diversification and ra ises issues for risk management.