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Measuring Financial Contagion by Local Gaussian Correlation

Author

Listed:
  • Støve, Bård

    () (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

  • Tjøstheim, Dag

    () (Dept. of Mathematics, University of Bergen)

  • Hufthammer, Karl Ove

    () (Dept. of Mathematics, University of Bergen)

Abstract

This paper examines financial contagion, that is, whether the cross-market linkages in financial markets increases after a shock to a country. We introduce the use of a new measure of local dependence (introduced by Hufthammer and Tjøstheim (2009)) to study the contagion effect. The central idea of the new approach is to approximate an arbitrary bivariate return distribution by a family of Gaussian bivariate distributions. At each point of the return distribution there is a Gaussian distribution that gives a good approximation at that point. The correlation of the approximating Gaussian distribution is taken as the local correlation in that neighbourhood. By examining the local Gaussian correlation before the shock (in a stable period) and after the shock (in the crisis period), we are able to test whether contagion has occurred by a proposed bootstrap testing procedure. Examining the Mexican crisis of 1994, the Asian crisis of 1997-1998 and the financial crisis of 2007-2009, we find some evidence of contagion based on our new procedure.

Suggested Citation

  • Støve, Bård & Tjøstheim, Dag & Hufthammer, Karl Ove, 2010. "Measuring Financial Contagion by Local Gaussian Correlation," Discussion Papers 2010/12, Norwegian School of Economics, Department of Business and Management Science.
  • Handle: RePEc:hhs:nhhfms:2010_012
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    File URL: http://hdl.handle.net/11250/164142
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    References listed on IDEAS

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    1. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
    2. Paulo Horta & Carlos Mendes & Isabel Vieira, 2008. "Contagion effects of the US Subprime Crisis on Developed Countries," CEFAGE-UE Working Papers 2008_08, University of Evora, CEFAGE-UE (Portugal).
    3. Gallo, Giampiero M. & Otranto, Edoardo, 2008. "Volatility spillovers, interdependence and comovements: A Markov Switching approach," Computational Statistics & Data Analysis, Elsevier, pages 3011-3026.
    4. Chiang, Thomas C. & Jeon, Bang Nam & Li, Huimin, 2007. "Dynamic correlation analysis of financial contagion: Evidence from Asian markets," Journal of International Money and Finance, Elsevier, vol. 26(7), pages 1206-1228, November.
    5. Mardi Dungey & Renee Fry & Brenda Gonzalez-Hermosillo & Vance Martin, 2005. "Empirical modelling of contagion: a review of methodologies," Quantitative Finance, Taylor & Francis Journals, pages 9-24.
    6. Mardi Dungey & Diana Zhumabekova, 2001. "Testing for contagion using correlations: some words of caution," Pacific Basin Working Paper Series 2001-09, Federal Reserve Bank of San Francisco.
    7. Okimoto, Tatsuyoshi, 2008. "New Evidence of Asymmetric Dependence Structures in International Equity Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(03), pages 787-815, September.
    8. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    9. Rodriguez, Juan Carlos, 2007. "Measuring financial contagion: A Copula approach," Journal of Empirical Finance, Elsevier, pages 401-423.
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    More about this item

    Keywords

    Financial Contagion; Crisis; Gaussian Correlation;

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General

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