Financial Contagion: Spillover Effects From NYSE to KSE Authored by: Salman Tahir

Mentors: Falak Sher and Mohsin Sadaqat

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Table of Contents

Abstract .......................................................................................................................................... 3

Financial Contagion: Spillover effects from NYSE to KSE ...................................................... 4

Introduction ................................................................................................................................. 4

Literature Review........................................................................................................................ 5

Data and Methodology ................................................................................................................ 6

Analysis and Discussion ............................................................................................................. 6

Correlation Analysis .............................................................................................................. 6

Vector Auto Regression Model (VAR) .................................................................................. 7

Impulse Response Functions ................................................................................................. 8

Graphical Analysis ............................................................................................................... 11

Concluding Remarks ................................................................................................................. 12

References .................................................................................................................................... 13

Abstract Financial Contagion has vast implications but this research paper attempts to study contagion in terms of

spillover from one capital market, i.e. NYSE to another, the KSE. The interrelationship between cross

border capital markets have been a key study among researchers for risk management and international

portfolio making. An empirical approach is adopted in this research and correlation, VAR Model and its

Impulse Response, and a graphical analysis is adopted to arrive at the desired findings. After all these are

considered it is finally concluded that shocks in NYSE can be felt in KSE. Nevertheless, any shocks in KSE

have nil effect on NYSE.

Financial Contagion: Spillover effects from NYSE to KSE

Introduction

Financial Contagion: The likelihood that significant economic changes in one country will spread

to other countries. Contagion can refer to the spread of either economic booms or economic crises

throughout a geographic region.

[Definition: Investopedia]

Financial Contagion was previously defined in a narrow manner, alas in contemporary world this

term has vast implications. Economists, financial analysts and researchers in a classical view

referred to this term as problems in the banking sector. Problems known as bank runs which create

bank panic and that eventually disrupt the financial system of a country and can even spill over to

other countries. Nonetheless in a contemporary approach to the term, financial contagion means

the problems in the banking sector, the problems in currency, debt crisis etc. The problems in

currency can be the dwindling foreign reserves due to which the country might seek help of

international monetary agencies. Consequently their financial position can spread crisis to other

economies too which have a high economic integration with them.

This research paper, however, attempts to study financial contagion in terms of spillover effects of

one capital market to another. The paper studies the effects of New York Stock Exchange on

Karachi Stock Exchange and attempts to find that does any adverse shock (in the former) which

triggers financial crisis spread to Pakistan or not?

In 2008, a slump in the real estate of United States spread to other sectors and eventually led the

NYSE to crash in September of the following year. This financial crisis spread to other countries

too and economic wizards term this as another event which changed the face of financial structure,

after the Great Depression of 1930’s. After the Global Financial Crisis of 1997 and then 2008,

researchers, portfolio managers, policy makers and investors study the relationship of capital

markets not just in bordering regions but also the relationship of distinct stock markets across the

world; this research paper attempts to do the same. There are numerous approaches to find

contagion between two cross border capital markets as highlighted further in the literature review.

Nonetheless, our approach will be to apply the empirical model, VAR and also the impulse

response function so as to get a clearer picture. The details of these are given further in Data and

Methodology.

Literature Review

The Global Financial Crisis resulted in financial contagion from many developed economies to the

growing ones. Research studies have confirmed that any movement in NYSE or any other major

capital market resulted in spillover effect to other capital markets.

Gulcin and Filiz (2012) argues that the Global Financial Crisis of 2008 was the first ever in recent

history which paralyzed even the heavy weight economies and their cronies. According to them

the primary reasons for this are the spillover from global to domestic economy and trade openness.

International Financial Contagion hast vast implications specially on those countries which have

greater trade integration with the rest of the world

Sulaiman and Adnan (2011) takes weekly data from 2000 to 2010 of KSE, NYSE, BSE and FTSE

to study the long run association among the different capital markets. The researchers concluded

that KSE have a positive correlation with the NYSE.

Ghulam et al. used the VAR Model to study the dynamic interrelationship of American Capital

Markets with the emerging economies in perspective of Global Financial Crisis and concluded that

the relationship is meaningful. In addition, the impulse response function shows further evidence

that the fluctuations in NYSE can also be felt in capital markets of emerging economies.

Iqbal et al. (2011) argues that the relationship between international capital markets is the primary

tool for international portfolio management and risk measurement. Through the Granger causality

test they find out that there is unidirectional causality from NYSE to KSE.

Ahmad and Gulasekaran (2007) states that globalization have made the capital markets vulnerable

to spillover effects. This is the primary reason of 1997 financial crisis, they state. Daily

observations of exchange rates from 1994-2002 were taken to find contagion in the pre-crisis,

crisis and post-crisis period and consequently, contagion was find in all periods except post-crisis.

It is suggested that in the post-crisis period the structure of markets operating might have changed.

It is important to mention that the comparison was done between USA and other emerging

economies, including Pakistan, India, Thailand, Singapore, Taiwan etc.

Besides this, it is important to mention that the references in Literature Review were for a side

reference since the research required secondary data of NYSE (composite i.e. NYA) and KSE 100

indexes which was found from Yahoo Finance. After that all the research was critical analysis,

comparisons, applying empirical models etc.

Data and Methodology

The Literature Review and skimming of many other research papers revealed that a lot of

researchers have used either weekly or monthly data of stock exchange indexes to study their

behavior. Nevertheless, we used daily observations of NYSE 100 Index and KSE 100 Index since

having a large sample size increases the probability of data accuracy. The data observed is from

January 3, 2005 to December 31, 2012, covering 1916 days (days with both markets open was

considered). Furthermore, the data sources were Yahoo Finance and official website of NYSE.

The empirical model Vector Auto-Regression is used and also its impulse function to find

contagion and study the shocks in both the markets. However, initially a correlation analysis was

also done. Moreover, a graphical analysis is also done to show the movement of the indexes in the

sample period.

Analysis and Discussion

Several analyses have been done to find the integration and contagion between the said capital

markets. In this regard 1916 days 100 index observations were taken as discussed above, then their

returns were taken, followed by a correlation analysis of which the results showed the following:

Correlation Analysis

The result of the correlation analysis shows that KSE and NYSE are highly correlated. As shown

in the table the correlation between the two is about 70%. Nonetheless, this analysis does not show

which capital market is the lead market; whether the operations of KSE affect NYSE or vice versa.

Therefore, the Vector Auto Regression Model is applied further to show integration between the

two capital markets and also to find contagion if any.

KSE NYSE

KSE 1

NYSE 0.702065 1

Vector Auto Regression Model (VAR)

A VAR is a regression model in which the relationship of two or more variables is studied. In VAR

one variable is taken independent and others are held dependent to study their relationship.

In this paper the following equations are formed and then VAR is applied on them:

(VAR system equations)

𝑹_𝑲𝑺𝑬𝒕 = ∝𝒕+ ∑ 𝑹_𝑲𝑺𝑬𝒕−𝟏 + ∑ 𝑹_𝑵𝒀𝑺𝑬𝒕−𝟏 + 𝝁𝟏𝒕

𝒎

𝒋=𝟏

𝒏

𝒊=𝟏

𝑹_𝑵𝒀𝑺𝑬𝒕 = ∝𝒕+ ∑ 𝑹_𝑲𝑺𝑬𝒕−𝟏 + ∑ 𝑹_𝑵𝒀𝑺𝑬𝒕−𝟏 + 𝝁𝟐𝒕

𝒎

𝒋=𝟏

𝒏

𝒊=𝟏

In the first equation Karachi Stock Exchange is held independent and NYSE dependent and it is

determined whether an activity in the former have any effect on the latter. Similarly, the second

equation determines the spillover effect of NYSE to KSE. Further the returns of both the 100

indexes are placed in the said model and the results are as follows:

The table above reveals our findings and shows:

KSE to KSE relationship is significant as shown by the t-statistics 5.3, whereas it is a rule

of thumb that near to 2 t-statistics is 1% significant. So KSE have own market effect,

which can be rumors, speculations etc. about the state of Pakistani economy or any other

macro/micro level factor like subsidy given to any industry/ new taxes imposed on any

industry etc.

The NYSE to KSE relationship is quite significant and contagion can be found as factually

1.9 t-statistics is 10% significant.

Alas no effect can be seen from KSE to NYSE, statistically, as a t-statistics equal to 2 is

1% significant but here it is less than 2.

Lastly, NYSE to NYSE relationship is -5.89 which means there is own market effects in

this US capital market. Own market effect can be the news of a large national firm on the

verge of collapse, a big fraud found in a major company

Moreover, the 15.7 and 17 in the F-statistics reveal that our model is stable, statistically. In

addition, the Adjusted R-square shows a value of 0.1% which is an indication of how well data

points fit a curve or line. It is said that Adjusted R-square increases when more useful variables

are added to it alas our value is very less. This is due to the fact that there are many other variables,

we are just studying contagion.

Impulse Response Functions

Impulse response highlights the reaction of any dynamic system in response to any outside change.

The following is the Impulse Response of KSE and NYSE, calculated by returns of both the

markets in VAR Model:

The Y-axis on each Impulse Response shows shocks in the respective markets, whereas the X-axis

shows the number of days the shocks prevail in that market.

Any own market effect in KSE leads to a shock that has an impact of about 3 days.

This can be news within the KSE or any other factor discussed previously

Likewise any shocks in NYSE can be felt in KSE too. Although the shock is of a

low intensity but it lasts for about 3 to 4 days.

The response of NYSE to KSE and KSE to NYSE are similar alas surprisingly the

shock in KSE that is felt in NYSE is a little higher than the previous case.

Just as KSE’s own market effect NYSE’s too is significant. More significant that

KSE indeed since there are negative shocks too. That may have been due to the

Financial Crisis of 2008, alas the shocks are significant for about 4 days.

Graphical Analysis

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

1/3/2005 1/3/2006 1/3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012

KSE NYSE

The diagram shows graphical analysis of KSE and NYSE 100 index from January 3, 2005 to

December 31, 2012. Thus it can be seen that both the stock markets have similar trading patterns

and a change in NYSE brings change in behavior of KSE. The spillover effects can be seen

especially during the financial crisis of 2008.

Concluding Remarks

This study focused on finding contagion from NYSE to KSE and vice versa. Based on our research

and findings we conclude that shocks in NYSE can be felt in KSE. Nonetheless any shocks in KSE

cannot be felt in NYSE. We first applied the correlation analysis which showed both markets are

correlated. Alas it did not indicated which the lead market is. Thus for that the VAR Model and its

Impulse Responses were used which helped in revealing that shocks in NYSE are felt in KSE.

Lastly, the graphical analysis showed the trend of 100 index in the 7 years sample period which

highlighted that while NYSE was bearish, similar pattern was seen here in KSE too.

References

Financial Contagion Definition [online]. (2014). Available from:

<http://www.investopedia.com/terms/c/contagion.asp>. [Accessed 12/05/2014]

(2014) 100 Indexes NYSE and KSE, Available at: http://finance.yahoo.com/ (Accessed: 12/25/2014)

Wikipedia (2014) Financial contagion, Available

at:http://en.wikipedia.org/wiki/Financial_contagion (Accessed: 12/05/2014)

AHMED M. KHALID and GULASEKARAN RAJAGURU (Winter 2006) 'Financial Market Integration in

Pakistan: Evidence Using Post-1999 Data', The Pakistan Development Review, 45(4 Part II ), pp. 1041–

1053.

Sulaiman D. Mohammad, Adnan Hussain (2011) 'The Dynamic Linkages of Pakistani and Global Stock

Markets: Evidence from Karachi Stock Exchange', Pak. J. Commer. Soc. Sci., 5(2), pp. 233-242.

A. Iqbal, N. Khalid and S. Rafiq (2011) 'Dynamic Interrelationship among the Stock Markets of India,

Pakistan and United States', World Academy of Science, Engineering and Technology, 5(2011-01-25), pp.

75-81.

Ghulam Mujtaba Kayani, Hui Xiaofeng, Saqib Gulzar (December 2013) 'Financial Contagion: Mean

Spillover Effect of US Financial Market to the Emerging Financial Markets in Perspective of Global

Financial Crises', Journal of Convergence Information Technology(JCIT), 8(17), pp. 58-68.

Arnulfo M. Castellanos, Francisco S. Vargas Luis G. Rentería (3-29-2012) 'The contagion from the 2007-

09 US stock market crash', International Journal of Banking and Finance, 8(4), pp. 67-81.