The phrase financial contagion draws on a concept whose root meaning lies in the field of epidemiology. Like almost all metaphors, this one has the power to illuminate and to mislead. Its referent is the spread of financial distress from one firm, market, asset class, nation, or geographical region to others. But, contagion carries with it other burdens of meaning. First, to refer to contagion, instead of merely to an epidemic, is to implicitly assert that there is a mechanism of transmission from one infected victim to other potential victims. For example, bubonic plague and malaria may give rise to epidemics, but these diseases are not contagious, being transmitted by the bite of a flea and the sting of a mosquito, rather than being spread fromone infected party to another. By contrast, some epidemics may be the result of truly contagious diseases in which the disease spreads directly from one victim to another through the direct transmittal of a pathogen, such as is the case with tuberculosis and AIDS. Second, because a contagious disease spreads from one infected host to others by some mechanism, the key to understanding such a malady is to comprehend the method of transmission. Finally, by invoking a metaphor of illness, financial contagion implies an economic disorder, dislocation, or disease.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1799485_code17292.pdf?abstractid=1799485&mirid=3

What is Financial Contagion

http://www3.tcmb.gov.tr/konferanslar/fsr/Sherman.pdf

Econometric measures of connectedness and systemic risk in the finance and insurance sectors

Financial contagion is described as a wealth effect in a continuous-time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long-term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined ~numerically! as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management. DURING THE F INANCIAL PANIC ASSOCIATED with the default of the Russian government in August 1998 and the subsequent collapse of the hedge fund Long Term Capital Management, numerous hedge funds, banks, and securities firms tried simultaneously to reduce exposures to a variety of financial instruments, such as Russian bonds, Brazilian stocks, U.S. mortgages, spreads between on-therun and off-the-run government securities, and spreads between swaps and U.S. Treasuries. Although the fundamental values of these positions would appear to have little correlation, during this financial crisis, the asset prices in these markets exhibited the following common empirical pattern: 1. Financial intermediaries suffered losses as prices moved against their positions; 2. Market depth and liquidity decreased simultaneously in several markets; 3. The volatility of prices increased simultaneously in several markets; and,

/pdf/contagion-as-a-wealth-effect-x6lwbwamie.pdf

Contagion as a Wealth Effect

We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, as well as between markets that do not directly share macroeconomic risks. A SPATE OF RECENT FINANCIAL CRISES-the Mexican crisis of 1995, the Asian crisis of 1997 to 1998, the default of the Russian government in August 1998, the sharp depreciation of the real in Brazil in 1999-have been accompanied by episodes of financial markets contagion in which many countries have experienced increases in the volatility and comovement of their financial asset markets on a day-to-day basis. The pattern of contagion has been uneven across both time and countries-with increased volatility and comovement occurring principally during times of financial and exchange rate crises-and with some countries, particularly those with emerging financial markets, having experienced the bulk of the contagion, while countries with more developed markets have remained relatively unscathed. Although heightened financial market volatility is to be expected within countries experiencing financial and exchange rate crises, the pattern of comovement across countries is not easily explained. Some of the increased comovement among countries that compete through trade or share close economic links can be rationalized on the basis of macroeconomic theory, but these theories are less persuasive in accounting for the increased comove

/pdf/a-rational-expectations-model-of-financial-contagion-45blvwg4c5.pdf

A Rational Expectations Model of Financial Contagion

This article proposes a new approach to evaluate contagion in financial markets. Our measure of contagion captures the coincidence of extreme return shocks across countries within a region and across regions. We characterize the extent of contagion, its economic significance, and its determinants using a multinomial logistic regression model. Applying our approach to daily returns of emerging markets during the 1990s, we find that contagion is predictable and depends on regional interest rates, exchange rate changes, and conditional stock return volatility. Evidence that contagion is stronger for extreme negative returns than for extreme positive returns is mixed.

/pdf/a-new-approach-to-measuring-financial-contagion-1pqzsxc5os.pdf

A new approach to measuring financial contagion

Title IV of the 1990 U.S. Clean Air Act Amendments offers firms facing high marginal costs for pollution abatement the chance to purchase the right to emit sulfur dioxide from firms with lower costs. In the long run such allowance trading may achieve substantial cost savings over an "enlightened" command and control program with a uniform emission-rate standard. But in the short run what has lowered costs is technical change and the fall in low-sulfur coal prices. Title IV of the 1990 U.S. Clean Air Act Amendments established a market for transferable sulfur dioxide emission allowances among electric utilities. The market offers firms facing high marginal costs for pollution abatement the opportunity to purchase the right to emit sulfur dioxide from firms with lower costs. It is expected to yield more cost savings than a command and control approach to environmental regulation. To evaluate the performance of the market for sulfur dioxide allowances, Carlson, Burtraw, Cropper, and Palmer use econometrically estimated marginal abatement cost functions for power plants affected by Title IV. They investigate whether the much-heralded fall in the cost of abating sulfur dioxide can be attributed to allowance trading. They find that for plants that use low-sulfur coal to reduce sulfur dioxide emissions, technical change and the fall in low-sulfur coal prices have lowered marginal abatement cost curves by more than half since 1985. And that is the main source of cost reductions rather than trading allowances per se. In the long run, allowance trading may achieve cost savings of $700 million to $800 million a year more than could be expected from an "enlightened" command and control program with a uniform emission-rate standard. But comparing potential cost savings in 1995 and 1996 with actual emissions costs suggests that most trading gains were unrealized in the first two years of the program. This paper-a product of Environment and Infrastructure, Development Research Group-is part of a larger effort in the group to examine the successes and failures of environmental regulation as a guide to formulating environmental policy. Maureen Cropper may be contacted at mcropper@worldbank.org

https://papers.ssrn.com/sol3/Delivery.cfm/371.pdf?abstractid=597216&mirid=1&type=2

Sulfur Dioxide Control by Electric Utilities: What Are the Gains from Trade?

Title IV of the 1990 Clean Air Act Amendments (CAAA) established a market for transferable sulfur dioxide (SO2) emission allowances among electric utilities. This market offers firms facing high marginal abatement costs the opportunity to purchase the right to emit SO2 from firms with lower costs, and this is expected to yield cost savings compared to a command‐and‐control approach to environmental regulation. This paper uses econometrically estimated marginal abatement cost functions for power plants affected by Title IV of the CAAA to evaluate the performance of the SO2 allowance market. Specifically, we investigate whether the much‐heralded fall in the cost of abating SO2, compared to original estimates, can be attributed to allowance trading. We demonstrate that, for plants that use low‐sulfur coal to reduce SO2 emissions, technical change and the fall in prices of low‐sulfur coal have lowered marginal abatement cost curves by over 50 percent since 1985. The flexibility to take advantage of these chan...

/pdf/sulfur-dioxide-control-by-electric-utilities-what-are-the-18w6kd2inh.pdf

Sulfur dioxide control by electric utilities : what are the gains from trade?

We take a first look at limitations on the use of energy-related tax credits contained in the General Business Credit (GBC) due to limitations within the regular corporate income tax as well as the AMT. Between 2000 and 2005, firms were unable to use all energy-related tax credits due to GBC limitations in the regular tax. The AMT has a smaller but still pronounced impact on the ability of firms to use these credits. Finally, we provide some illustrative calculations to demonstrate how the AMT can lead to very different levelized costs of producing electricity from a wind power project.

https://papers.ssrn.com/sol3/Delivery.cfm/nber_w14110.pdf?abstractid=1149356&mirid=1

Energy Tax Incentives and the Alternative Minimum Tax

Title IV of the 1990 Clean Air Act Amendments (CAAA) established a market for transferable sulfur dioxide (SO2) emission allowances among electric utilities. This market offers firms facing high marginal abatement costs the opportunity to purchase the right to emit SO2 from firms with lower costs, and is expected to yield cost savings compared to a command and control approach to environmental regulation. This paper uses econometrically estimated marginal abatement cost functions for power plants affected by Title IV of the CAAA to evaluate the performance of the SO2 allowance market. Specifically, we investigate whether the much-heralded fall in the cost of abating SO2, compared to original estimates, can be attributed to allowance trading. We demonstrate that, for plants using low-sulfur coal to reduce SO2 emissions, technical changes and the fall in low-sulfur coal prices have lowered marginal abatement cost curves by over 50% since 1985. The flexibility to take advantage of these changes is the main source of cost reductions, rather than trading per se. In the long run, allowance trading may achieve cost savings of $700-$800 million per year compared to an "enlightened" command and control program characterized by a uniform emission rate standard. The cost savings would be twice as great if the alternative to trading were forced scrubbing. However, a comparison of potential cost savings in 1995 and 1996 with actual emissions costs suggests that most trading gains were unrealized in the first two years of the program.

Sulfur-Dioxide Control By Electric Utilities: What Are the Gains from Trade?

We take a first look at limitations on the use of energy-related tax credits contained in the General Business Credit (GBC) due to limitations within the regular corporate income tax as well as the...

/pdf/energy-tax-incentives-and-the-alternative-minimum-tax-2zg7ikjg9w.pdf

Curtis Carlson

Papers

Sulfur Dioxide Control by Electric Utilities: What Are the Gains from Trade?

Sulfur dioxide control by electric utilities : what are the gains from trade?

Energy Tax Incentives and the Alternative Minimum Tax

Sulfur-Dioxide Control By Electric Utilities: What Are the Gains from Trade?

Energy Tax Incentives and the Alternative Minimum Tax