Three Different Ways Synchronization Can Cause Contagion in Financial Markets

TL;DR

This paper explores three mechanisms by which synchronization among human decision-makers can lead to financial market contagion, using models of oscillators, feedback, and communication to understand turbulent market periods.

Contribution

It introduces a novel framework combining integrate-and-fire oscillators, feedback mechanisms, and communication models to analyze contagion pathways in financial markets.

Findings

Synchronization in market indices can trigger turbulence.

Feedback between strategies and performance amplifies contagion.

Communication influences decision-making and market dynamics.

Abstract

We introduce tools to capture the dynamics of three different pathways, in which the synchronization of human decision-making could lead to turbulent periods and contagion phenomena in financial markets. The first pathway is caused when stock market indices, seen as a set of coupled integrate-and-fire oscillators, synchronize in frequency. The integrate-and-fire dynamics happens due to change blindness, a trait in human decision-making where people have the tendency to ignore small changes, but take action when a large change happens. The second pathway happens due to feedback mechanisms between market performance and the use of certain (decoupled) trading strategies. The third pathway occurs through the effects of communication and its impact on human decision-making. A model is introduced in which financial market performance has an impact on decision-making through communication between people. Conversely, the sentiment created via communication has an impact on financial market performance. The methodologies used are: agent based modeling, models of integrate-and-fire oscillators, and communication models of human decision-making