Financial Contagion: A Propagation Simulation Mechanism

A simulation mechanism is designed for crisis propagation accommodating contagion. A new co-evolutionary market model is described, where some of the technical traders change their behaviour during crisis and their decisions become largely influenced by market sentiment rather than based on fundamental factors and underlying strategies. Analyzing agents’ behaviour, it is observed that the herd mentality intensifies during crisis. This paper focuses on the transformation of market interdependence into contagion, and on contagion effects. A multi-national platform is build first, to allow different type of players to implement their trading strategies while considering information from both domestic and foreign markets. Traders’ strategies and the performance of the simulated domestic market is trained using historic prices of domestic and foreign markets, while optimizing artificial markets’ parameters through immune particle swarm optimization techniques. Further elements are introduced contributing to the transformation of technical into herd traders. A GARCH-copula is applied next to calculate the tail dependence between the affected market and the origin of the crisis. That parameter is used in the fitness function for selecting the best solutions within the evolving population of possible model parameters, and therefore in the optimization criteria for contagion simulation. The results show that the proportion of herd traders increases in the net market order for optimum contagion simulations. While technical traders’ behaviour corresponds to propagating a crisis through interdependence, herd behaviour corresponds to propagating through contagion. If contagion could be avoided or transformed back to interdependence, with the timely response of national governments and international institutions, a crisis would be more manageable. Further research could introduce a recovery mechanism … into the model through the design of national and international intervention.