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Heteroscedasticity biases tests for contagion based on correlation coefficients. When contagion is defined as a significant increase in market co-movement after a shock to one country, previous work suggests contagion occurred during recent crises. This paper shows that correlation coefficients are conditional on market volatility. Under certain assumptions, it is possible to adjust for this bias. Using this adjustment, there was virtually no increase in unconditional correlation coefficients (i.e., no contagion) during the 1997 Asian crisis, 1994 Mexican devaluation, and 1987 U.S. market crash. There is a high level of market co-movement in all periods, however, which we call interdependence.
We use a Bayesian time-varying coefficient model to measure contagion and interdependence, and we apply it to the Chilean FX market during the 2001 Argentine crisis. The proposed framework works in the joint presence of heteroskedasticity and omitted variables, without knowledge of the crisis timing prior to the empirical analysis. It can distinguish between contagion and interdependence, as well as between unusually strong or weak market comovements. In a natural experiment based on our application, we find that the proposed framework works well in practice. In the application, we find evidence of some contagion from Argentina and some interdependence with Brazil.
This paper presents a framework based on correlation analysis to test for contagion during the episode of financial turmoil surrounding the Asian crisis. In particular, we calculate conditional and unconditional correlation coefficients for 15 countries. We advocate the use of synchronous instead of synchronized data to correctly measure stock market comovements. Considering the two different phases of the Asian crisis, reveals that synchronized data lead to an over-identification of contagion for the early Thailand crisis phase but an under-identification of contagion during the late Hong Kong crisis phase. When using synchronous data, we find little evidence of a significant change in the transmission mechanisms from Thailand to any of the other country in our sample as most financial shocks are thus transmitted through non-crisis-contingent channels. Contrary to the Thailand finding, we find evidence of contagion from the Hong Kong stock market to most of the other stock markets in our sample. This is in contrast with the findings of Forbes and Rigobon (2002) and suggests that most shocks are transmitted through crisis-contingent channels. Overall, our findings should caution researchers and practitioners alike when drawing conclusions based on synchronized data.
Contagion represents a significant change in cross-market linkages precipitated by a crisis and is properly measured only after taking into account the interdependence or extant linkages prevailing between markets. Since it is well known that stock return volatilities and correlations are stochastic in the absence of a crisis, interdependence between markets should reflect the time varying nature of these covariances. We measure contagion in the presence of stochastic interdependence using data on stock indices from South East Asian countries around the July 1997 crisis. Since stock return covariances are observed with error, this suggests casting our model in a state space framework which is estimated using a multivariate Kalman filter. In the presence of stochastic interdependence, we find reliable evidence of contagion between Thailand and Indonesia, Malaysia, and the Philippines but not between Thailand and Hong Kong or Singapore.
Bekaert, Harvey, and Ng (2005a) define contagion as quot;correlation over and above what one would expect from economic fundamentalsquot;. Based on a two-factor asset pricing specification to model fundamentally-driven linkages between markets, they define contagion as correlation among the model residuals, and develop a corresponding test procedure. In this paper, we investigate to what extent conclusions from this contagion test depend upon the specification of the time-varying factor exposures. We develop a two-factor model with global and regional market shocks as factors. We make the global and regional market exposures conditional upon both a latent regime variable and two structural instruments, and find that, for a set of 14 European countries, this model outperforms more restricted versions. The structurally-driven increase in global (regional) market exposures and correlations suggest that market integration has increased substantially over the last three decades. Using our optimal model, we do not find evidence that further integration has come at the cost of contagion. We do find evidence for contagion, however, when more restricted versions of the factor specifications are used. We conclude that the specification of the global and regional market exposures is an important issue in any test for contagion.
This paper examines stock market co-movements. It begins with a discussion of several conceptual issues involved in measuring these movements and how to test for contagion. Standard tests examine if cross-market correlation in stock market returns increase during a period of crisis. The measure of cross-market correlations central to this standard analysis, however, is biased. The unadjusted correlation coefficient is conditional on market movements over the time period under consideration, so that during a period of turmoil when stock market volatility increases, standard estimates of cross-market correlations will be biased upward. It is straightforward to adjust the correlation coefficient to correct for this bias. The remainder of the paper applies these concepts to test for stock market contagion during the 1997 East Asian crises, the 1994 Mexican peso collapse, and the 1987 U.S. stock market crash. In each of these cases, tests based on the unadjusted correlation coefficients find evidence of contagion in several countries, while tests based on the adjusted coefficients find virtually no contagion. This suggests that high market co-movements during these periods were a continuation of strong cross-market linkages. In other words, during these three crises there was no contagion, only interdependence.
"Financial Contagion: The Viral Threat to the Wealth of Nations covers a lot of territory. It is, of course, terribly important to analyze case histories to discover potential triggers, mechanisms of transmission, and viable ways to contain the damage of financial contagion. The problem is, as these articles amply demonstrate, that there’s always a new virus or a mutation of a former one lurking in some corner of the financial world. We don’t know what it is or where it is. And, even if we had some inkling, there’s almost never enough time to develop a financial flu shot." --SeekingAlpha.com The latest insights on financial contagion and how both nations and investors can effectively deal with it. The domino-style structure in which the financial system exists is a perilous one. Although historically, the financial system has been able to deal with major shocks, the fact remains that our financial system is not as secure as it should be. Recent years have brought about too many examples of contagion and systemic risk. That is why Financial Contagion is such an important read. In it, the serious concerns that revolve around our fragile economic system are investigated, researched, and explained. Throughout the book, Kolb offers valuable insights on this dilemma as he compiles the history of financial contagion, highlights the latest research on systemic failure and interrelated markets, and analyzes the risks and consequences we face moving forward. Examines the importance of careful regulation and what must be done to stabilize the global financial system Includes contributed chapters from both academics and experienced professionals, offering a variety of perspectives and a rich interplay of ideas Details how close we are to witnessing a financial contagion that could devastate the world economy We have been harshly reminded of how fragile our economic ecosystem is. With Financial Contagion, you'll hold a better understanding of what needs to be done to strengthen our system and safeguard our financial future.