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Financial Market Contagion or Spillovers

Financial Market Contagion or Spillovers

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Published by: Ahmed on Nov 19, 2008
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Financial Market Contagion or SpilloversEvidence from Asian Crisis using Multivariate GARCH ApproachbyAhmed M. Khalid
*
 andGulasekaran Rajaguru
*
 May 2006Abstract
The increased episodes of the financial crises throughout the world in the 1990s motivated researchinterests to identify the channels through which such crises spread from one country to the entire regionand across regions and to suggest policies to avoid the worst of such crises. Researchers haveidentified several factors that may spark and induce contagion of the crisis. Strong trade and financialmarket linkages may contribute to contagion of the crises. This also implies that, even economies withstrong fundamentals could not escape contagion. This study attempts to identify and trace the allegedorigin and the subsequent path of the currency contagion using data from a sample of selected Asiancountries. For empirical estimation, we use high frequency data (daily observation) on exchange ratesfrom 1994 to 2002. We split the sample in to four periods (full, pre –crisis, crisis and post-crisisperiods), construct a multivariate GARCH model and apply Granger causality test to identify the inter-linkages among exchange rate markets in selected Asian countries. The evidence suggests thatcurrency market links increased during and after the crisis. However, we found a weak support forcontagion in the pre-crisis period.
JEL Classification: F30, F31, F32, F34, F41,Key words:
Asian Crisis, Market Linkages, Contagion, Multivariate GARCH, Granger Causality
 Corresspondance to:
Ahmed M. Khalid, Associate Professor of Economics and Finance, School of Business, Bond University, Gold Coast, QLD 4229, Australia, Fax: (617) 5595-1160, E-mail:akhalid@bond.edu.au * Bond University Australia
 
 
Financial Market Contagion or SpilloversEvidence from Asian Crisis using Multivariate GARCH Approach
1. Introduction
The decade of 1990s witnessed a significant increase in the number of financial crisesand financial market collapses in various regions around the globe. It is argued thatinappropriate and hasty financial sector reforms in many parts of the developingworld in the 1990s left the markets unstable and vulnerable to even minor shocks.The increased financial and trade sectors interdependence within a region furtheraggravated the problem. The crises in Latin America (1994), Asia (1997) and Russia(1998) are examples of such shocks spreading from one country to another. In theliterature, this is labeled
contagion
. As a result, there is a growing concern amongresearchers and policy makers to investigate the cause and effect of such crises.Many economists, in the recent past, have studied this phenomenon boththeoretically and empirically. Recently, research has been intensified to study theissue of currency contagion using data from Latin American and Asian countries.However, the existing research is subject to some limitations. This study attempts toprovide a more comprehensive and broader coverage to this issue. We use amultivariate GARCH approach on high frequency data to study the currencycontagion in the context of the 1997 Asian financial crisis. Specifically, this paperstudies the co-movements in exchange rates from a comprehensive sample of 10Asian countries, including six crisis-hit East Asian economies. We study cross-country contagion within foreign exchange markets in the sample countries. For
1 
 
empirical estimation, we use daily observations on exchange rate, construct amultivariate GARCH model suitable for our analysis and apply Granger causalitytests to investigate currency market inter-linkages.This study is organized in the following manner. Section 2 provides a brief review of theoretical and empirical existing literature on currency contagion with afocus on the 1997 Asian financial crisis. Data and estimation techniques arediscussed in section 3. Section 4 reports the results of causality tests in meantransmission using the multivariate GARCH technique. Finally, the conclusions aredrawn in section 5.
2. Financial Market Contagion: Theoretical and Empirical Perspective
The Asian financial crisis started with the collapse of Thai baht on 2
nd
July 1997. Thesequence of events later spread the currency crisis into a full-blown financial andeconomic crisis not only in Thailand but in the entire Southeast and East Asian regionand then to the world
1
. In a short time span of few months, most of the regionaleconomies which were enjoying double digit economic growth were trapped into theworst recession of the last four decades.
2
By the end of 1997, currency depreciationin US dollar term was severe and unprecedented in Asia. At the peak of the currencycrisis, losses relative to June 1997 exchange rates were: Thai baht 56 per cent; thePhilippines peso 54 per cent; Malaysian ringgit 40 per cent; Korean won 78 per cent;and Indonesia rupiah 76 per cent. The collapse of the currency markets also affected
1
Ariff and Khalid (2000), Table 2.2, pp: 35-36.2 

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