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

  • Fernando Broner
  • Gaston Gelos
  • Carmen Reinhart

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