This paper presents a canonical, econometric model of contagion and investigates the conditions under which contagion can be distinguished from inter-dependence. In a two-country (market) set-up it is shown that for a range of fundamentals the solution is not unique, and for sufficiently large values of the contagion coefficients it has interesting bifurcation properties with bimodel density functions. The extension of the model to herding behaviour is also briefly discussed. To identify contagion effects in the presence of inter-dependencies the equations for individual markets or countries must contain country (market) specific forcing variables. This sheds doubt on the general validity of the correlation based tests of contagions recently proposed in the literature which do not involve any country (market) specific fundamentals. We show that ignoring inter-dependence can introduce an upward bias in the estimate of the contagion coefficient, and using Monte Carlo experiments we show that this could be substantial.
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Find related papers by JEL classification: C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: 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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