The 1990‰fs has been punctuated by a series of severe financial and currency crises: the Exchange Rate Mechanism (ERM) attacks of 1992; the Mexican peso collapse of 1994; the East Asian crisis of 1997; the Russian collapse of 1998; and the Brazilian devaluation of 1999. One striking characteristic of these crises was how an initial country-specific shock was rapidly transmitted to markets of very different sizes and structures around the globe. This has prompted a surge of interest in "contagion". The recent empirical literature testing if contagion exists, especially, the each of these tests based on cross-market correlation coefficients reaches the same general conclusion: (i) cross-market correlations of the financial prices usually increase significantly after the relevant crisis and therefore, contagion occurred during the period under investigation, (ii) the volatility of financial prices is time-varying; (ii) when volatility is high, the price changes in major markets tend to become highly correlated. These results suggest a new direction for research on financial market co-movements. Why do so many markets of such different sizes, structures, and geographic locations generally show such a high degree of co-movement? This paper proposes a contagion model based on the statistical mechanics explaining how shocks can be transmitted across markets, and investigate the characteristics of the mean and variance dynamics of the mean, variance, and covariance generated from the model. We show that the model help explain the stylized facts found in the empirical literature testing if contagion exists. 1 Baig, Taimur, and Ilan Goldfajn (1998). ‰gFinancial Market Contagion in the Asian Crises.‰h IMF Working Paper No. 98/155. 2 Forbes, Kristin, and Roberto Rigobon (1999). ‰gNo Contagion, Only Interdependence: Measuring Stock Market Co-Movements.‰h NBER Working Paper 7267. 3 King, Mervyn, and Sushil Wadhwani (1990). ‰gTransmission of Volatility Between Stock Markets.‰h Review of Financial Studies, 3(1):5-33. 4 Lee, Sang Bin, and Kwang Jung Kim (1993). ‰gDoes the October 1987 Crash Strengthen the Co-Movements Among National Stock Markets?‰h Review of Financial Economics, 3(1):89- 102.
