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When in peril, retrench: testing the portfolio channel of contagion

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Author Info
Fernando Broner
Gaston Gelos
Carmen Reinhart

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Abstract

It has frequently been argued that portfolio adjustments by international investors may transmit financial shocks across markets and borders. This notion, however, has not yet been examined with microeconomic data. One plausible mechanism through which shocks may propagate is through the effect of past gains and losses on investors’ risk aversion. We test this hypothesis using a unique data set of the monthly country asset allocation of individual emerging market funds. We first present a simple model that analyzes the effect of heterogeneous changes in investors’ risk aversion on portfolio decisions and stock prices. We then present empirical results that show that, consistent with the model, when funds’ returns are relatively low compared to those of other funds, they adjust their holdings toward the average (or benchmark) portfolio. In other words, they tend to sell the assets of countries in which they were "overweight" and increase their exposure to countries in which they were "underweight." Building on this insight, we construct a matrix of financial interdependence reflecting the extent to which countries share a set of overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2004)
Issue (Month): Jun ()
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Handle: RePEc:fip:fedfpr:y:2004:i:jun:x:8

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Keywords: Risk ; Investments;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  3. Borensztein, Eduardo R. & Gelos, R. Gaston, 2001. "A Panic-Prone Pack? The Behavior of Emerging Market Mutual Funds," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Sergio L. Schmukler & Tatiana Didier & Paolo Mauro, 2006. "Vanishing Contagion?," IMF Policy Discussion Papers 06/01, International Monetary Fund. [Downloadable!]
  2. Itay Goldstein & Assaf Razin & Hui Tong, 2008. "Liquidity, Institutional Quality and the Composition of International Equity Outflows," NBER Working Papers 13723, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Anna Pavlova & Roberto Rigobon, 2005. "Wealth Transfers, Contagion, and Portfolio Constraints," NBER Working Papers 11440, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Demirguc-Kunt, Asli & Serven, Luis, 2009. "Are all the sacred cows dead ? implications of the financial crisis for macro and financial policies," Policy Research Working Paper Series 4807, The World Bank. [Downloadable!]
  5. Leila Ali & Yan Kestens, 2006. "Contagion and Crises Clusters: Toward a Regional Warning System?," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 142(4), pages 814-839, December. [Downloadable!] (restricted)
  6. Kannan, Prakash & Kohler-Geib, Fritzi, 2009. "The uncertainty channel of contagion," Policy Research Working Paper Series 4995, The World Bank. [Downloadable!]
  7. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2007. "Why Do Emerging Economies Borrow Short Term?," NBER Working Papers 13076, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Jokipii , Terhi & Lucey, Brian, 2006. "Contagion and interdependence: measuring CEE banking sector co-movements," Research Discussion Papers 15/2006, Bank of Finland. [Downloadable!]
    Other versions:
  9. Irina Tytell & Selim Elekdag & Ravi Balakrishnan & Stephan Danninger, 2009. "The Transmission of Financial Stress from Advanced to Emerging Economies," IMF Working Papers 09/133, International Monetary Fund. [Downloadable!]
  10. Melisso Boschi & Aditya Goenka, 2007. "Relative Risk Aversion And The Transmission Of Financial Crises," CAMA Working Papers 2007-28, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
  11. Michael Bleaney, & Liliana Castilleja Vargas, . "Real Exchange Rates, Valuation Effects and Growth in Emerging Markets," Discussion Papers 07/12, University of Nottingham, CREDIT. [Downloadable!]
  12. Bernardo Guimaraes & Stephen Morris, 2006. "Risk and Wealth in a Model of Self-Fulfilling Currency Attacks," Levine's Bibliography 122247000000001115, UCLA Department of Economics. [Downloadable!]
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