Fluctuating attention and financial contagion

Financial contagion occurs when return and volatility transmit between fundamentally unrelated sectors. Our equilibrium model shows that contagion arises because investors pay fluctuating attention to news. As a negative shock hits one sector, investors pay more attention to it. This raises the volatility of equilibrium discount rates resulting in simultaneous spikes in cross-sector correlations and volatilities. We test the economic mechanism of the model on fundamentally unrelated U.S. industries, which are identified using their customer-supplier relationships. Consistent with the model’s predictions, empirical evidence shows that fluctuating attention generates return and volatility spillovers between fundamentally unrelated industries.