In general, one could relate the contagion channel to Keynes’ concept of “animal spirits”. The impact of this channel manifests itself very quickly in the equity and foreign exchange market-falling equities and one-way movement of the exchange rate. Even the stock market sentiment is often driven by the FIIs led activities based on their “risk on – risk off” approaches.
Often the movement in one market reinforces movements in the other. Overall negative sentiments can quell investment plans of portfolio investors, deter long term direct investors to commit funds and can have negative effect on the financial markets.