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Correlation Analysis of Financial Contagion: What One Should Know before Running a Test

Author

Listed:
  • Giancarlo Corsetti

    () (Universit� di Roma III, Yale University and CEPR)

  • Marcello Pericoli

    () (Banca d'Italia)

  • Massimo Sbracia

    () (Banca d'Italia)

Abstract

This paper presents a general test of contagion in financial markets based on bivariate correlation analysis � 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.

Suggested Citation

  • Giancarlo Corsetti & Marcello Pericoli & Massimo Sbracia, 2001. "Correlation Analysis of Financial Contagion: What One Should Know before Running a Test," Temi di discussione (Economic working papers) 408, Bank of Italy, Economic Research and International Relations Area.
  • Handle: RePEc:bdi:wptemi:td_408_01
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    References listed on IDEAS

    as
    1. Eichengreen, Barry & Rose, Andrew K & Wyplosz, Charles, 1996. "Contagious Currency Crises," CEPR Discussion Papers 1453, C.E.P.R. Discussion Papers.
    2. Jeanne, Olivier & Masson, Paul, 2000. "Currency crises, sunspots and Markov-switching regimes," Journal of International Economics, Elsevier, vol. 50(2), pages 327-350, April.
    3. Corsetti, Giancarlo & Pesenti, Paolo & Roubini, Nouriel, 1999. "What caused the Asian currency and financial crisis?," Japan and the World Economy, Elsevier, vol. 11(3), pages 305-373, October.
    4. Kristin J. Forbes & Roberto Rigobon, 2002. "No Contagion, Only Interdependence: Measuring Stock Market Comovements," Journal of Finance, American Finance Association, vol. 57(5), pages 2223-2261, October.
    5. Sebastian Edwards, 1998. "Interest Rate Volatility, Capital Controls, and Contagion," NBER Working Papers 6756, National Bureau of Economic Research, Inc.
    6. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters?: A chronicle of the Asian crisis," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 537-560, August.
    7. Michelacci, Claudio & Zaffaroni, Paolo, 2000. "(Fractional) beta convergence," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 129-153, February.
    8. Kaminsky, Graciela L. & Reinhart, Carmen M., 2000. "On crises, contagion, and confusion," Journal of International Economics, Elsevier, vol. 51(1), pages 145-168, June.
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    More about this item

    Keywords

    contagion; financial crisis; factor model; correlation analysis;

    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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