Transmission of Financial Crises and Contagion: A Latent Factor Approach

Transmission of Financial Crises and Contagion: A Latent Factor Approach

Transmission of Financial Crises and Contagion: A Latent Factor Approach

Transmission of Financial Crises and Contagion: A Latent Factor Approach

Synopsis

Financial crises often transmit across geographical borders and different asset classes. Modeling these interactions is empirically challenging, and many of the proposed methods give different results when applied to the same data sets. In this book the authors set out their work on a generalframework for modeling the transmission of financial crises using latent factor models. They show how their framework encompasses a number of other empirical contagion models and why the results between the models differ. The book builds a framework which begins from considering contagion in thebond markets during 1997-1998 across a number of countries, and culminates in a model which encompasses multiple assets across multiple countries through over a decade of crisis events from East Asia in 1997-1998 to the sub prime crisis during 2008. Program code to support implementation of similar models is available.

Excerpt

Contagion in financial markets is a general term that is widely used in academic research, policy debates, and the media to represent the spread of shocks through asset markets within countries and across national borders during times of financial crises. Contagion as a description of financial crises, was first introduced during the Asian financial crisis of 1997–98, beginning with the large depreciation of the Thai bhat on July 2, 1997. the term was subsequently used to explain the spread of shocks during other financial crises such as the Russian bond default in 1998, the collapse of Long Term Capital Management (LTCM) in September 1998, the crisis in Brazilian asset markets in early 1999, the dot-com bust/correction in 2000, the Argentinian crisis from 2001 to 2005, and more recently the global financial crisis that began with the U.S. subprime mortgage and credit crisis stemming from mid-2007.

Despite the widespread use of contagion to describe the transmission of shocks, much of the earlier empirical work lacked a coherent framework in which to estimate and test the presence of contagion. Part of the problem stemmed from the difficulty in measuring contagion per se, as the presence of contagion in contributing to increases in asset market volatility during financial crises was always inferred and never directly measured. the approach adopted by the authors in this collection of papers is to use a modelling framework to identify and to test for contagion for various markets and episodes in times of stress. a common underlying theme of the modeling . . .

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