Correlation Analysis of Financial Contagion: What One Should Know before Running a Test
AbstractThis paper presents a general test of contagion in financial markets based on bivariate correlation analysis Â– a test that can be interpreted as an extension of the normal correlation theorem. Contagion is defined as a structural break in the data generating process of rates of return. Using a factor model of returns, our theoretical framework nests leading contributions in the literature as special cases. We show that the tests proposed in the literature are conditional on a specific yet arbitrary assumption about the variance of country specific shocks. Using the Hong Kong stock market crisis in October 1997 as a representative case study, our results suggest that, for a number of pairs of country stock markets, the hypothesis of 'no contagion' can be rejected only if the variance of country specific shocks is set to levels that are not consistent with the evidence.
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Bibliographic InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 408.
Date of creation: Jun 2001
Date of revision:
contagion; financial crisis; factor model; correlation analysis;
Find related papers by JEL classification:
- F30 - International Economics - - International Finance - - - General
- C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
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