Showing papers on "Financial contagion published in 2003"
TL;DR: In this article, a multinomial logistic regression model is proposed to evaluate contagion in financial markets, which captures the coincidence of extreme return shocks across countries within a region and across regions.
Abstract: 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.
879 citations
TL;DR: In this article, the authors present a theoretical framework to highlight possible channels for the international transmission of financial shocks and present a simple multi-country asset pricing model to classify the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy.
Abstract: . This paper presents a theoretical framework to highlight possible channels for the international transmission of financial shocks. We first review the different definitions and measures of contagion adopted by the literature. We then use a simple multi-country asset pricing model to classify the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy. In particular, the model shows how crises can be transmitted across countries, without assuming ad hoc portfolio management rules or market imperfections. Finally, tracking our classification, we survey the results of the empirical literature on contagion.
731 citations
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TL;DR: Fast and furious contagion as mentioned in this paper is characterized by "the unholy trinity": (i) a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor.
Abstract: Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.
564 citations
TL;DR: Fast and furious contagion as discussed by the authors is characterized by "the unholy trinity": (i) a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor.
Abstract: Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.
422 citations
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TL;DR: In this paper, the authors developed a simple two-country, two-good model, in which the real exchange rate, stock and bond prices are jointly determined, and showed that stock market prices are correlated internationally even though their dividend processes are independent, providing a theoretical argument in favor of financial contagion.
Abstract: This paper develops a simple two-country, two-good model, in which the real exchange rate, stock and bond prices are jointly determined. The model predicts that stock market prices are correlated internationally even though their dividend processes are independent, providing a theoretical argument in favor of financial contagion. The foreign exchange market serves as a propagation channel from one stock market to the other. The model identifies interconnections among stock, bond and foreign exchange markets and characterizes their joint dynamics as a three-factor model. Contemporaneous responses of each market to changes in the factors are shown to have unambiguous signs. These implications enjoy strong empirical support. Estimation of various versions of the model reveals that most of the signs predicted by the model indeed obtain in the data, and the point estimates are in line with the implications of our theory. Moreover, the factors we extract from daily data on stock indexes and exchange rates explain a sizable fraction of the variation in a number of macroeconomic variables, and the estimated signs on the factors are consistent with our model's implications. We also derive agents' portfolio holdings and identify economic environments under which they exhibit a home bias, and demonstrate that an international CAPM obtaining in our model has two additional factors.
290 citations
TL;DR: The authors surveys the various definitions and taxonomies of international financial contagion in the academic literature and popular press and relates it to existing evidence on co-movements in international asset prices, on the growth and volatility of international capital flows and on the relationship between flows and asset prices.
Abstract: This article surveys the various definitions and taxonomies of international financial contagion in the academic literature and popular press and relates it to the existing evidence on co-movements in international asset prices, on the growth and volatility of international capital flows and on the relationship between flows and asset prices. The central argument of the article is that the empirical evidence is not as obviously consistent with the existence of market contagion as many researchers, the press, or market regulators believe. Policy implications of this alternative viewpoint are presented.
156 citations
TL;DR: This article showed that spillovers caused by banks' exposures to a crisis country help predict flows in third countries after the Mexican and Asian crises, but not after the Russian crisis, suggesting that countries might reduce contagion risk by diversifying the sources of their financing and by carefully monitoring borrowing from creditors exposed to potential crisis countries.
149 citations
TL;DR: In this article, the propagation mechanisms of the Hong Kong index on the Eurostoxx, Nikkei and Dow Jones indexes during the Asian financial crisis were discussed. And the authors show that the methodologies proposed by Forbes and Rigobon [J. Finance 57 (2002) 2223] and by Corsetti et al. are highly affected by the windows used and by the presence of omitted variables.
143 citations
TL;DR: In this paper, the authors organize and evaluate recent research on international financial contagion and find that the different mechanisms by which a crisis can spread greatly differ from each other both in their causes and implications.
Abstract: Despite the growing popularity of blaming ‘contagion’ for international financial crises, contagion remains an elusive concern. Without a clear understanding of financial contagion and the mechanisms through which it works, we can neither assess the problem nor design appropriate policy measures to control it. This paper organizes and evaluates recent research on international financial contagion. The main finding is that the different mechanisms by which a crisis can spread greatly differ from each other both in their causes and implications. Policy measures that do not take these differences into account may do more harm than good.
81 citations
TL;DR: This paper surveys the various definitions and taxonomies of international financial contagion in the academic literature and popular press and relates it to existing evidence on comovements in international asset prices, on the growth and volatility of international capital flows and on the relationship between flows and asset prices.
Abstract: This article surveys the various definitions and taxonomies of international financial contagion in the academic literature and popular press and relates it to the existing evidence on comovements in international asset prices, on the growth and volatility of international capital flows and on the relationship between flows and asset prices. The central argument of the article is that the empirical evidence is not as obviously consistent with the existence of market contagion as many researchers, press, or market regulators believe. Policy implications of this alternative viewpoint are presented.
41 citations
TL;DR: In this article, the volume is divided into five traditional areas of finance: macroeconomy, banking, securities markets, pension issues, and regulations, and four crosscutting messages emerge.
Abstract: The volume is divided into five traditional areas of finance: the macroeconomy, banking, securities markets, pension issues, and regulations. Four cross-cutting messages emerge. First, the erosion of national frontiers by trade, tourism, migration, and capital account liberalization means that residents of all countries have substantial financial assets, and often liabilities denominated in foreign currencies at home or abroad. Any analysis of national financial systems must take this into account. More important, this factor constrains governments' use of macroeconomic and financial policy and may contribute to economic fluctuations. Second, individuals and firms benefit substantially from the improved risk and return menu associated with global diversification. Diversification is of particular importance in developing countries where the lack of size and diversity of the national economy results in instability in the value of production. Third, the small size of most developing countries limits the efficiency and quality of financial services: banking, equity markets, and pensions. Thus cross-border provision of financial services, one facet of globalization, has potential benefits for small economies. Fourth, taking full advantage of the opportunities presented by globalization and minimizing its costs depend on effective regulation and supervision to ensure good quality information, transparency, market integrity, and prudent investing by banks and pension funds.
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TL;DR: In this article, the authors present a theoretical framework to highlight possible channels for the international transmission of financial shocks, and use a simple multi-country asset pricing model to classify the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy.
Abstract: This paper presents a theoretical framework to highlight possible channels for the international transmission of financial shocks. We first review the different definitions and measures of contagion adopted by the literature. We then use a simple multi-country asset pricing model to classify the main elements of the current debate on contagion and provide a stylized account of how a crisis in one country can spread to the world economy. In particular, the model shows how crises can be transmitted across countries, without assuming ad hoc portfolio management rules or market imperfections. Finally, tracking our classification, we survey the results of the empirical literature on contagion.
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TL;DR: Fast and furious contagion as mentioned in this paper is characterized by "the unholy trinity": (i) a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor.
Abstract: Over the last 20 years, some financial events, such as devaluations or defaults, have triggered an immediate adverse chain reaction in other countries -- which we call fast and furious contagion. Yet, on other occasions, similar events have failed to trigger any immediate international reaction. We argue that fast and furious contagion episodes are characterized by "the unholy trinity": (i) they follow a large surge in capital flows; (ii) they come as a surprise; and (iii) they involve a leveraged common creditor. In contrast, when similar events have elicited little international reaction, they were widely anticipated and took place at a time when capital flows had already subsided.
01 Jul 2003
TL;DR: In this article, a synthesis of theoretical and empirical work on international financial contagion is presented, where the authors argue that the recent focus on better understanding of high-frequency financial returns data and decision making at the market microstructure level are promising avenues for understanding the transmission of shocks across markets and countries.
Abstract: This paper attempts a synthesis of theoretical and empirical work on international financial contagion. Although a professional consensus on the appropriate definitions of contagion has yet to emerge, we document substantial research progress towards this goal. On the empirical front, determining when returns are ‘excessive’ is a pre-condition for designing effective policy response to crises. At the theoretical level, tracing the observed herding behavior to market participants’ uncertain beliefs and information asymmetries is a key element for understanding how contagious effects arise. It is argued that the recent focus on better understanding of high-frequency financial returns data and decision making at the market microstructure level are promising avenues for understanding the transmission of shocks across markets and countries.
TL;DR: In this article, the authors identify macroeconomic determinants of sovereign bond spreads in Argentina, Brazil and Mexico and discuss the economic policies underlying the divergent fortunes experienced by these countries over 1993-2001.
Abstract: The aim of this paper is to identify the macroeconomic determinants of sovereign bond spreads in Argentina, Brazil and Mexico and discuss the economic policies underlying the divergent fortunes experienced by these countries over 1993-2001. Based on a consistent theoretical framework (unlike a bulk of the former literature), we derive and empirically test those determinants, namely: a) real GDP growth; b) gross capital inflows in GDP terms, and c) the debt service burden, also measured as percentage of GDP. Our econometric analysis suggests that a permanent change in the former variables have a more significant and robust impact than transitory shocks do on spreads. It also stresses that financial contagion or risk-aversion variables have some meaningful role in explaining default premia across different emerging market crises.
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TL;DR: In this paper, the authors examined the impact of sovereign rating changes on the financial markets of other emerging market economies and found that the spillover effects tend to be regional and not global.
Abstract: Credit rating changes for long-term foreign currency debt may act as a wake-up call with upgrades and downgrades in one country affecting other financial markets within and across national borders. Such a potential (contagious) rating effect is likely to be stronger in emerging market economies, where institutional investors’ problems of asymmetric information are more present. This empirical study complements earlier research by explicitly examining cross-security and cross-country contagious rating effects of credit rating agencies’ sovereign risk assessments. In particular, the specific impact of sovereign rating changes during the financial turmoil in emerging markets in the latter half of the 1990s has been examined. The results indicate that sovereign rating changes in a ground-zero country have a (statistically) significant impact on the financial markets of other emerging market economies although the spillover effects tend to be regional.
TL;DR: In this article, the authors propose a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers.
Abstract: This paper proposes a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers. In emerging markets, the dominant presence of dedicated fund managers whose compensation is linked to the outperformance of their portfolio relative to a benchmark index, and of global fund managers whose compensation is linked to the absolute returns of their portfolios, leads to portfolio decisions that result in systematic interactions between asset prices even in the absence of asymmetric information. The model endogenously determines the optimal amount of cash holdings or leverage, the incidence of relative value versus macro hedge fund strategies, and how prices can systematically deviate from the long-term fundamental value for long periods of time, with limits to the arbitrage of this differential. Managerial compensation contracts, while optimal at a firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when a negative shock to one emerging market affects another market negatively.
TL;DR: In this paper, the authors analyse a model in which bank deposits are insured and there is an exogenous cost of bank capital, and show that capital requirements, which are constrained optimal for national banks, result in under-investment by multinational banks.
Abstract: We analyse a model in which bank deposits are insured and there is an exogenous cost of bank capital. The former effect results in bank over-investment and the latter in under-investment. Regulatory capital requirements introduce investment distortions, which are a constrained optimal response to these market imperfections. We show that capital requirements, which are constrained optimal for national banks, result in under-investment by multinational banks. The extent of under-investment depends upon the home bank's riskiness, the extent of international diversification, and the liability structure (branch or subsidiary) of the multinational. Capital requirements for international banks should therefore reflect these effects. We relate our findings to observed features of multinational banks and we discuss the possible existence of a multinational bank channel for financial contagion.
TL;DR: In this paper, the authors develop a model of multi-asset trading, populated by a number of informed strategic speculators facing a trade-off between the maximization of short- versus long-term utility of their wealth, uninformed market-makers, and liquidity traders, in which the liquidation values of the available securities depend on idiosyncratic and systematic sources of risk.
Abstract: Financial contagion is the propagation of a shock to one security across other fundamentally unrelated securities. In this paper, we examine how heterogeneity of insiders' information about fundamentals may induce excess comovement among asset prices, i.e., beyond the extent justified by the structure of the economy. We develop a model of multi-asset trading, populated by a number of informed strategic speculators facing a trade-off between the maximization of short- versus long-term utility of their wealth, uninformed market-makers, and liquidity traders, in which the liquidation values of the available securities depend on idiosyncratic as well as systematic sources of risk. We show that, even in a setting where such insiders are rational, risk-neutral, and financially unconstrained, financial contagion can be an equilibrium outcome of a semi-strong efficient market, if and only if they receive heterogeneous information about those sources of risk and strategically trade on it. Rational market-makers use the observed aggregate order flow to update their beliefs about the random terminal payoffs of the assets. Imperfectly competitive speculators engage in portfolio rebalancing activity to mask their information advantage. Asymmetric sharing of information among insiders prevents the market-makers from learning about their individual signals and trades with sufficient accuracy. Incorrect cross-inference about fundamentals and contagion then ensue. When used to analyze the transmission of shocks across countries, our model suggests that more adequate regulation of the process of generation and disclosure of information in emerging markets may reduce their vulnerability to international financial contagion.
01 Jan 2003
01 Jan 2003
TL;DR: In this article, the authors examine the options for monetary integration in the Andean Community, in the context of existing literature on the subject, and conclude that the traditional literature on monetary integration has been developed largely with the intent of explaining integration in Europe, and to consider instead monetary integration, one that takes into account the particular characteristics of these economies: fear of floating, original sin, dollarization, and large and volatile capital flows, subject to financial contagion and sudden stops.
Abstract: Object of this paper is to examine the options for monetary integration in the Andean Community, in the context of existing literature on the subject. After a survey of the relevant literature, some stylised facts of the Andean Community are examined. Optimum Currency Area criteria are considered, as are some indictors of fear of floating and dollarization within the region. I argue that the traditional literature on monetary integration has been developed largely with the intent of explaining integration in Europe, and to consider instead monetary integration in Latin America we need a new framework, one that takes into account the particular characteristics of these economies: fear of floating, original sin, dollarization, and large and volatile capital flows, subject to financial contagion and sudden stops. In conclusion I examine the pros and cons of three possible options available to the Andean Community: mutual exchange rate pegging, a common regional currency and dollarization.
TL;DR: This article applied a technique using heteroscedasticity adjusted correlation coefficients to discriminate between contagion and interdependence in European capital markets associated with seven big financial shocks between 1997 and 2002.
Abstract: This paper investigates contagion to European capital markets associated with seven big financial shocks between 1997 and 2002. We apply a technique using heteroscedasticity adjusted correlation coefficients to discriminate between contagion and interdependence. The analysis focuses on a comparison between developed Western European markets and emerging capital markets in Central and Eastern Europe. We find little evidence of significant increases in cross-market linkages after the crises under investigation. The Central and Eastern European capital markets are not more vulnerable to contagion than Western European markets.
TL;DR: In this article, the authors modeled an economy in which deposit-taking banks of a Diamond/Dybvig style and an asset market coexist, and analyzed the effect of a run on a single bank on the entire financial system.
Abstract: An economy in which deposit-taking banks of a Diamond/Dybvig style and an asset market coexist is modelled. Firstly, within this framework we characterize distinct financial systems depending on the fraction of households with direct investment opportunities that are less efficient than those available to banks. With this fraction comparatively low, the evolving financial system can be interpreted as market-oriented. In this system, banks only provide efficient investment opportunities to households with inferior investment alternatives. Banks are not active in the secondary financial market nor do they provide any liquidity insurance to their depositors. Households participate to a large extent in the primary as well as in the secondary financial markets. In the other case of a relatively high fraction of households with inefficient direct investment opportunities, a bank-dominated financial system arises, in which banks provide liquidity transformation, are active in secondary financial markets and are the only player in primary markets, while households only participate in secondary financial markets. Secondly, we analyze the effect a run on a single bank has on the entire financial system. Interestingly, we can show that a bank run on a single bank causes contagion via the financial market neither in market-oriented nor in extremely bank-dominated financial systems. But in only moderately bank-dominated (or hybrid) financial systems fire sales of long-term financial claims by a distressed bank cause a sudden drop in asset prices that precipitates other banks into crisis.
TL;DR: In this paper, the authors present a set of reprint articles for which IEEE does not hold copyright. Full text is not available on IEEE Xplore for these articles, but full text can be found on the Internet Archive.
Abstract: This publication contains reprint articles for which IEEE does not hold copyright. Full text is not available on IEEE Xplore for these articles.
01 Jan 2003
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TL;DR: In this article, the authors compared the performance of country specific and regional indicators of reserve adequacy in predicting, out of sample, the balance of payment crisis affecting the South East Asian region during the 1997-98 period.
Abstract: In this paper we compared the performance of country specific and regional indicators of reserve adequacy in predicting, out of sample, the balance of payment crisis affecting the South East Asian region during the 1997-98 period. A Dynamic Factor method was used to retrieve reserve adequacy indicators. The empirical findings suggest clear evidence of financial contagion.
TL;DR: In this article, the authors compared the performance of country speci c and regional indicators of reserve adequacy in predicting, out of sample, out-of-sample, reserve performance.
Abstract: In this paper we compared the performance of country speci…c and regional indicators of reserve adequacy in predicting, out of sample,
TL;DR: In this paper, the authors examined the cross-security and cross-country contagious rating effects of credit rating agencies' sovereign risk assessments and found that sovereign rating changes in a ground-zero country have a statistically significant impact on the financial markets of other emerging market economies although the spillover effects tend to be regional.
Abstract: Credit rating changes for long-term foreign currency debt may act as a wake-up call with up-grades and downgrades in one country affecting other financial markets within and across national borders. Such a potential (contagious) rating effect is likely to be stronger in emerging market economies, where institutional investors' problems of asymmetric information are more present. This empirical study complements earlier research by explicitly examining cross-security and cross-country contagious rating effects of credit rating agencies' sovereign risk assessments. In particular, the specific impact of sovereign rating changes during the financial turmoil in emerging markets in the latter half of the 1990s has been examined. The results indicate that sovereign rating changes in a ground-zero country have a (statistically) significant impact on the financial markets of other emerging market economies although the spillover effects tend to be regional.
01 Jan 2003
TL;DR: In this paper, the authors argue that the crisis was built on national weaknesses that were greatly magnified by a flawed international financial system; the initial policy recommendations from Washington, especially to raise interest rates sharply and to close a large number of financial institutions, were inappropriate, and made matters worse, not better.
Abstract: Broadly speaking, there were two initial explanations for the unexpected nature of the Asian financial crisis. The first explanation emphasized the common structural problems (soft rot) in the crisis Asian countries, and the second explanation emphasized the primary roles of investor panic and financial contagion. In my view, the crisis was built on national weaknesses that were greatly magnified by a flawed international financial system; the initial policy recommendations from Washington, especially to raise interest rates sharply and to close a large number of financial institutions, were inappropriate, and made matters worse, not better.
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TL;DR: In this paper, the authors use an asymmetric information framework to derive five propositions, to integrate empirical evidence and to suggest policy implications in emerging markets, including that opaque information hinders foreign market entrants and can worsen the position of local investors.
Abstract: Portfolio flows channeled via institutional investors were the most dynamic capital flows to emerging markets in the 1990s. We use an asymmetric information framework to derive five propositions, to integrate empirical evidence and to suggest policy implications. Opaque information in emerging markets hinders foreign market entrants. Moreover, following financial opening, institutional investors can worsen the position of local investors due to unintentionally creating unbalanced diversification and obscure risks. Finally, foreign institutional investors often amplify investment booms and financial contagion. Therefore, capital account and financial market liberalization needs to be accompanied by careful regulation.