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When in Peril, Retrench

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  • International Monetary Fund

Abstract

One plausible mechanism through which financial market shocks may propagate across countries is through the effect of past gains and losses on investors'' risk aversion. We first present a simple model on how heterogeneous changes in investors'' risk aversion affect portfolio decisions and stock prices. Second, we empirically show that, when funds'' returns are below average, 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," increasing their exposure to countries in which they were "underweight." Based on this insight, we construct a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. This index can improve predictions about which countries are likely to be affected by contagion from crisis centers.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/131.

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Length: 34
Date of creation: 01 Jul 2004
Date of revision:
Handle: RePEc:imf:imfwpa:04/131

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Related research

Keywords: Emerging markets; investors; risk aversion; stock market; mutual funds; international investors; expected returns; international finance; capital markets; international capital markets; fixed costs; stock market capitalization; foreign investors; index funds; short sales; risk premium; fixed income; investment banks; international capital; global equity markets; equity funds; investment decisions; total market capitalization;

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References

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  1. Ranil Salgado & Luca Antonio Ricci & Francesco Caramazza, 2000. "Trade and Financial Contagion in Currency Crises," IMF Working Papers 00/55, International Monetary Fund.
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  16. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1589-1622, October.
  17. Albert S. Kyle, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, American Finance Association, vol. 56(4), pages 1401-1440, 08.
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  19. Guillermo A. Calvo & Enrique G. Mendoza, 1999. "Regional Contagion and the Globalization of Securities Markets," NBER Working Papers 7153, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Jokipii, Terhi & Lucey, Brian, 2007. "Contagion and interdependence: Measuring CEE banking sector co-movements," Economic Systems, Elsevier, Elsevier, vol. 31(1), pages 71-96, March.
  2. Bayoumi, Tamim & Fazio, Giorgio & Kumar, Manmohan & MacDonald, Ronald, 2007. "Fatal attraction: Using distance to measure contagion in good times as well as bad," Review of Financial Economics, Elsevier, Elsevier, vol. 16(3), pages 259-273.

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