Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

What does the term contagion refer to in financial markets?

1. The process of stabilizing numerous securities at once

2. A method to minimize losses during market downturns

3. The tendency of market movements to be transmitted between markets

4. A strategy to avoid market risks altogether

The correct answer is: The tendency of market movements to be transmitted between markets

The term contagion in financial markets specifically refers to the tendency of market movements, particularly downturns, to spread across different asset classes or markets. This phenomenon can occur when negative developments in one market lead to declines in related markets. For instance, if investors start selling off stocks in one country due to economic concerns, it can create a ripple effect, causing investors in other countries to also sell, even if their local economies are stable. Understanding contagion is essential for investors and risk managers as it highlights the interconnectedness of financial markets. This interlinking means that events in one region or sector can significantly impact others, potentially leading to broader market instability. Recognizing the possibility of contagion is vital for developing strategies to mitigate risk, especially during periods of heightened volatility or crisis. The other choices address different concepts. Stabilizing numerous securities is unrelated to the transmission effect described by contagion, while minimizing losses during downturns refers to risk management strategies rather than the phenomenon of contagion itself. Avoiding market risks altogether is a more absolute strategy that doesn’t account for the reality of interconnected markets, as completely avoiding risks is seldom feasible in practice.