[Contagion and Spillover effects: Is it Contagion or just Interdependence and How Do We Measure it?]

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Abstract

Most available literature on the contagion effects of crises focuses primarily on currency crises and does not address the plethora of natural disasters that have occurred recently. In this thesis we discuss some different methods proposed in the literature to analyse the propagation mechanism of a crisis and to verify the presence of any discontinuity (contagion). In particular, we examine the recent tests introduced by Forbes and Rigobon (2002) and the DCC test introduced by Rigobon (2002a) that is also robust to endogenous and omitted variables. We consider the propagation mechanisms of the global indices, Nikkei and Dow Jones during the U.S financial crisis. We demonstrate that the methodologies proposed by Forbes & Rigobon (2002), is highly affected by presence of omitted variables: we propose some analyses to strengthen the robustness of these tests.

Table of Content

Chapter 1: Introduction22

Chapter 2: Literature Review25

Financial Spillovers31

Sources of Spillovers33

Financial Contagion35

Interdependence and Contagion37

Chapter 3: Empirical Tests45

Contagion Tests45

Rigobon's DCC test47

Chapter 4: Results and Discussion50

Correlation analysis50

Variance analysis54

Window analysis55

DCC test analysis56

Chapter 5: Conclusion58

References59

Chapter 1: Introduction

The 1990s were punctuated by a series of severe financial and currency crises: the 1992 ERM attacks, the 1994 Mexican peso collapse, the 1997 East Asian crises, the 1998 Russian collapse, the 1998 LTCM crisis, the 1999 Brazilian devaluation, and the 2000 technological crisis. One striking characteristic of several of these crises was how an initial Country-specific shock was rapidly transmitted to markets of very different sizes and structures around the globe. This has prompted a surge of interest in “contagion”. This is a relevant issue even from the empirical and theoretical point of view. Volatility transmission and contagion are issues relevant at an international level by themselves and because they have important consequences for (i) monetary policy, (ii) optimal asset allocation, (iii) risk measurement, (iv) capital requirements, and (v) asset pricing. Many authors have written about the propagation mechanisms featured in these crises.

In particular, they have focused on the question whether the relationships between markets during tranquil periods are different from those during periods of crisis. Often during financial crises we observe strong co-movements in prices and in the volatility between markets. We can also observe an increase in the covariance of the returns and sometimes in their correlation. In this paper, “contagion” - as opposed to “interdependence” - conveys the idea that international propagation mechanisms are discontinuous. There is no agreement on this definition and many other definitions have been proposed.

If contagion is a structural break in the data-generating process ...