Vienna 11/20/2014 1

Detecting Financial Contagion in a Multivariate System

Bertrand CandelonIPAG Business School

Kent Business School - January 26th 2015

Vienna 11/20/2014 2

Motivation – Financial Crises

Sources of financial crises :

- Fundamental based Crises (Flood and Garber, 1984)

- Non Fundamental based Crises (Obstfeld, 1996)

Self-fulfilling prophecies Moral Hazard Contagion

Vienna 11/20/2014 3

Motivation – Contagion I

Contagion

Crisis originates in a particular country then it diffuses in other countries and disappear

Inherited from the medical framework – The virus is transmitted from patients to patients then disappear

Vienna 11/20/2014 4

Motivation – Contagion II

Evaluating Contagion

It requires : 1/ transmission channels2/ stable transmission

but difficult to obtain:

So weak form - Shift-contagion

Vienna 11/20/2014 5

Motivation – Contagion IIIShift-Contagion

Contagion – Temporary increase in the correlation (dependance) between 2 markets

- King & Wadwhani 1990- Baig and Goldfajn 1999,…

Bivariate system + Exogenous brake dates

Vienna 11/20/2014 6

Motivation – Contagion IV

Forbes and Rigobon (2002) Testing for increase in correlation is biased by an increase in volatility

corrh > corrl simply because sxl<sx

h

So FR proposes a correction to conditional correlation

where

Vienna 11/20/2014 7

Motivation – Our Contribution

Testing for shift-contagion taking into account for

. Endogenous break-date

. Multivariate set-up (third country effect)

. Test for distinctive breaks in variance and correlation

How? Sequential Testing Procedure (STP) relying on Qu and Perron (QP) (2007)

Vienna 11/20/2014 8

Sketch of the talk

2. Sequential testing Procedure (STP)

. The set-up

. Procedure

. Testing

. Monte-Carlo Experiments

3. Empirical application (Asia 1997)

9

STP – The Set-up I

Stationnary n-dimentional VAR

S Matrix var-cov, no normality assumption required only weak assumption (Theorems A4-A5 QP).

Vienna 11/20/2014

Vienna 11/20/2014 10

STP – The Set-up IIS is decomposed into variances an covariance terms (FR).

. Interpretation of the contagion will be different if the breaks occur in variance or covariance terms at the same date/different date. More precise analysis for third country effect.

11

STP – The Procedure I

1- Test for m distinct unknown variance breaks.

2- Test for n distinct unknown correlation breaks (using standardized residuals).

3- Test for the distinctiveness between variance and correlations breaks.

Note that QP allow to run 1 and 2 simultaneously, but it is technically non tractable for m and m’ large.

Vienna 11/20/2014

12

STP – Testing IBased on LR test as in QP.

1- hyp:

log-lik

and

Vienna 11/20/2014

13

STP – Testing II

2- hyp:

log-lik

Vienna 11/20/2014

14

STP – Testing III (Perron-Oka, 2011)

3- Distinctivness (common break)

Critical value are bootstrapped simulated as suggested in Perron-Oka (2011)

Vienna 11/20/2014

15

STP – Monte-Carlo experiments I

Vienna 11/20/2014

16

STP – Monte-Carlo experiments II

Vienna 11/20/2014

17

STP – Monte-Carlo experiments III

Vienna 11/20/2014

18

STP – Monte-Carlo experiments IV

Vienna 11/20/2014

19

STP – Monte-Carlo experiments V

Vienna 11/20/2014

20

STP – Monte-Carlo experiments VI

Vienna 11/20/2014

Vienna 11/20/2014 21

Empirical – Case presentation I. 8 daily stock index returns.

. 01/07/1996 -06/30/1998.

. Japan, Hong Kong, Thailand, Indonesia, Taiwan, Malaysia, Korea and the Philippines.

. Underlying model : VARX(1,1) model with the U.S. stock index (t-1).

. The confidence intervals have been determined by a block bootstrap of 1,000 repetitions with blocks of 20 days.

Vienna 11/20/2014 22

Empirical – Case presentation II

. Asian crisis – Thai Baht collapse July 2th, 1997, but markets were stressed before.

. Second shock – Hong-Kong October

. Objectives: More precise analysis of the contagion process during the Asian crisis using STP.

Vienna 11/20/2014 23

Empirical – STP

Vienna 11/20/2014 24

Vienna 11/20/2014 25

Vienna 11/20/2014 26

Empirical – STP

Vienna 11/20/2014 27

Vienna 11/20/2014 28

Vienna 11/20/2014 29

Vienna 11/20/2014 30

Vienna 11/20/2014 31

Vienna 11/20/2014 32

Vienna 11/20/2014 33

Vienna 11/20/2014 34

Economic Analysis

• Break in variances are occuring before correlation ones.

• distinctiveness between variance and correlation breaks.

• Crucial in analysis the contagion process.

Vienna 11/20/2014 35

Economic Analysis

Analysis of contagion is important to understand financial crises.

• Endogenous break

• Multiviate approach is required

• Separate breaks in variance and in correlation

Vienna 11/20/2014 36

Extension

Analysis of contagion on European CDS markets.

• On going application for the revision of the paper….