Review of Development Economics, 19(1), 62–74, 2015

DOI:10.1111/rode.12126

Evidence for Financial Contagion in Endogenous

Volatile Periods

Erdem Kilic and Veysel Ulusoy*

Abstract
The objective of this study is to analyze cross-border contagious dynamics in both foreign exchange
markets and stock exchange markets. Propagation is analyzed with respect to the transmission of excessive
volatility that is endogenously determined. The contagion process is discussed in the context of financial
systems, foreign direct investments and trade. Implementing a vector autoregressive-multivariate general-
ized autoregressive conditional heteroskedasticity (VAR-MGARCH) model, we show that country-specific
turbulence in financial markets is able to create unanticipated financial contagion across countries. Diversi-
fied trade and financial relations decrease the risk of exposure to contagion from external markets. The
world’s largest economies, however, play a price-setter role, and diversification is of secondary importance.
Asymmetric transmission of the empirically predicted contagion prevails in the latter case.

1. Introduction
Financial crises have been discussed extensively in the financial economics literature
since the early 1990s. The contagious effects of financial crises pose several questions,
such as why some crises spread quickly and widely while others are constrained to a
small group of countries; how financial distress is transmitted across countries;
whether these spillover channels change over time; and whether crises spread purely
to countries with existing vulnerabilities or whether they open up new fault lines.1
The research literature proposes using a wide range of models to address these
questions regarding the harm caused by financial contagious crises on countries’
economic status, including information asymmetry (Calvo and Mendoza, 2000), busi-
ness cycle approaches (Allen and Gale, 2000), incompleteness of payment systems
(McAndrews and Roberds, 1995) and interbank markets (van Rijckeghem and
Weder, 2000).
The first empirically founded analysis of financial contagion was developed by
Grubel and Fadner (1971), who analyze the interdependence of international equity
markets. They identified the reduction in the variance of expected returns on portfo-
lios as a result of returns on foreign assets and capital value changes of assets as ben-
efits of international diversification. More recent empirical research begins with King
and Wadhwani (1990), who incorporate an information-based model with a simulta-
neous equations model (SEM). Idiosyncratic country risk is modeled together with
expectations of systematic information on local stock markets. Contagion occurs
when a turbulent event in one market is transmitted to other markets.
Eichengreen et al. (1994) develop a probability-test-based framework that tests
for contagion as a non-zero probability of associating foreign crises with domestic

* Kilic: MEF University, Department of Economics, Maslak Ayazaga Cad. 4, 34396—Istanbul, Tel: +90-
212-3953670; Fax: +90-212-3953692; E-mail: kilice@mef.edu.tr. Ulusoy: Yeditepe Universitesi, Ticari
Bilimler Fakultesi, Kayisdagi Cad., 34755 Atasehir—Istanbul.

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 FINANCIAL CONTAGION IN ENDOGENOUS VOLATILE PERIODS 63

crises within a latent factor model with alternate conditioning information. Baig and
Goldfajn (1999) investigate contagious effects in the case of the Asian financial
crisis of 1997–1998 using vector autoregressive (VAR) methodology. They conduct a
cross-country correlation analysis among currencies, stock markets, interest rates,
and sovereign spreads. They find evidence for contagion in the foreign exchange
market and tentative evidence in the stock market. Forbes and Rigobon (2002)
report on empirical research on the conditions for rejecting parameter stability.
Rejection based on parameter instability and/or diffusion of heteroskedasticity
among different types of shocks generates bias in the rejection process. Forbes and
Rigobon argue that an unadjusted correlation coefficient is not appropriate for
measuring contagious effects. Volatility during crisis periods increases, causing the
calculated correlation coefficient of the crisis periods to expand. Therefore, the cor-
relation coefficient of crisis periods is biased compared with that of tranquil periods.
Corsetti et al. (2005) state that existing research has made arbitrary assumptions
about the variance of country-specific shocks within the originating country in the
Forbes–Rigobon (2002) model.
Dungey and Zhumabekova (2001) note problems in identifying the correct obser-
vation windows. They observe that long windows include different regimes, which
causes the autocorrelation coefficient to be only a linear combination of short-crises
windows, pointing to increased volatility compared with the small sample size. Favero
and Giavazzi (2002) test for the presence of abnormalities in the propagation of
devaluation expectations for European Exchange Rate Mechanism (ERM) members
during the early 1990s. Applying a full-information technique, they inquire whether
transmission processes across markets evolve abnormally during periods of extreme
returns to a greater extent than during “normal” times. Bae et al. (2003) refine the
Eichengreen et al. (1994) latent factor model, in which the coincidence of extreme
return shocks across emerging markets during the 1990s are tested using daily returns.
They suggest that contagion is conditionally predictable based on prior information
and can be explained by the regional interest-rate level, exchange rate changes and
conditional stock return volatility.
The primary objective of empirical research on contagion is to determine if the
strength of the transmission mechanism remains stable over time. Our research uses
the same definition of contagion that has been agreed upon in recent empirical
research on contagion (Forbes and Rigobon, 2002; Dungey and Zhumabekova, 2001;
Favero and Giavazzi, 2002).2
Contagion is primarily considered a significant change in the way that country-
specific shocks are transmitted internationally. The null hypothesis of the stability of
the transmission mechanism is tested across both calm and turbulent periods against
the alternative hypothesis of structural breaks in the parameters of the transmission
mechanism. In international macroeconomic theory, it is presumed that economic dis-
turbances will be transmitted across countries.
Our research study aims to contribute to the contagion test approach introduced by
Favero and Giavazzi (2002). We introduce a multivariate generalized autoregressive
conditional heteroskedasticity (MGARCH) analysis when identifying the dummy
variables that account for common or local financial shocks. The arbitrary assumption
of allocating a dummy variable when residuals exceed the standard deviation of the
reduced VAR model by three times is substituted by a VAR-MGARCH that cap-
tures excessive volatility or extreme outliers in the variable returns.3 The core hypoth-
esis is analyzed in a theoretical modeling framework that treats financial shocks as
endogenous. Furthermore, regarding explanatory variables in testing for contagion,

© 2015 John Wiley & Sons Ltd

64 Erdem Kilic and Veysel Ulusoy

two different markets are utilized for each country in terms of exchange rates and
stock market returns. This study aims to gain new insight into the propagation of
spillover effects in international financial markets.

2. Considerations of Contagion Causes: Financial Systems, Interdependence

and Capital Flows
Although trade liberalization and financial deregulation have benefited some devel-
oping economies, current financial systems have difficulties in coping with cross-
border financial shocks. Financial liberalization not only allowed the financial system
to fulfill its role in allocating resources but also led to the return of banking crises, of
which there have been many since the early 1990s.4
Emerging economies had difficulties in developing the appropriate macroeco-
nomic design to manage the effects of intensified capital flows in the new financial
environment of post-cold-war globalization.5 In this context, the fragility of the
banking and financial systems could amplify the adverse effects of speculative
attacks on, for example, currency pegs or other cross-border related financial claims.
Market failure in such incomplete markets with weak domestic financial systems can
lead to contagion.
Allen and Carletti (2008) note that through financial fragility, small shocks can
again lead to larger changes in asset prices. This volatility can, in turn, result in signifi-
cant disruptions and crises. With contagion, amplification is repeated; namely, a shock
in one region can spill over to other areas and have much larger effects than did the
original.
Regarding general responsibility, Roubini and Frankel (2001) blame industrialized
countries for the weak financial systems in emerging markets. They identify short-
term impacts on developing countries with three major macroeconomic variables in
industrialized countries: growth rates, real interest rates and exchange rates. They
also note that these macroeconomic variables closely interact with the pursued trade
policy of emerging markets. Trade is a fundamental source of international capital
inflow and foreign currency, which is utilized in foreign debt payments. Thus, the
pursued trade policy directly affects the sound operation of the financial system.
Conventionally, foreign direct investments (FDIs) are observed as another engine
in rising globalization.6 In our study, we focus on trade and FDI linkages as indicators
of globalization, which could explain contagion within the illustrated discussion
regarding financial systems and market failure or fragility.

FDI and Trade Linkages

We briefly illustrate FDI and trade linkages for each country in our data sample. FDI
and trade linkages follow a similar pattern. Diversification in trade partners and
investor relationships are central to globalization discourse.
Trade partners are in general more diversified than FDI partner countries, with
exceptions being Japan and Mexico, as they are deeply connected to the USA in trade
and FDI relations. In almost all countries, FDIs and trade follow the same pattern.
The most important trade partners simultaneously constitute the most important FDI
partners.
Strong relationships beyond pure financial and economic themes must be consid-
ered when analyzing interdependence in financial markets. Germany is the leader in

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 FINANCIAL CONTAGION IN ENDOGENOUS VOLATILE PERIODS 65

the EU and, therefore, is involved in the robust European economic bloc. One impor-
tant factor is that the UK has traditionally had close cultural dependence with the
USA and Europe. Investment linkages between Japan and the USA are quite deep,
and these countries serve as leaders and economic world centers alongside the emerg-
ing dominant competitor China, which itself is traditionally connected with Hong
Kong and other Asian markets. Turkey is closely attached to the European trade
zone and is aiming for potential entry into the EU. As one would expect, Mexico’s
geographical location has led to a close partnership with the USA.

3. Methodology

Data
We use daily data spanning from 05:1993 to 05:2011. The official exchange rate and
the most important stock exchange market for the each of the seven countries that are
studied are selected. The exchange rates include the US dollar, British pound sterling,
Japanese yen, euro (or German mark7 before 2000), Chinese yuan, Mexican peso and
Turkish lira. The stock exchange market variables include the Dow Jones Index,
Nikkei Index, FTSE 100 Index, DAX, Hang Seng Index, Mexican Stock Exchange
Index (Bolsa Mexicana de Valores) and Istanbul Stock Exchange Index (IMKB).
We take the logarithmic return for each variable to achieve stationarity in the
analysis. The data for the stock exchange variables and exchange rates are obtained
from the Yahoo finance database and the corresponding central banks.

Transmission of Excessive Volatility—Contagion

Our methodology refines the Favero and Giavazzi (2002) contagion model approach
through a range of asymmetric adjustments within a MGARCH approach. They
define contagion as a significant increase in cross-market correlation (structural break
in the parameters) during periods of extreme movement (highly volatile periods). In
comparison, interdependence prevails if the observed comovement is in line with the
historically measured simultaneous feedback between the two markets. In contrast to
“normal” times, transmission processes across markets may be abnormal during
periods of extreme returns. Therefore, the objective was to create a VAR-MGARCH
analysis to control for the interdependence between asset returns. Therefore, the
identification of unexpected shocks that may be transmitted across countries (conta-
gion) is made using autoregressive conditional heteroskedasticity (ARCH)-adjusted
effects and extreme movements of residuals.
We apply the following procedure to measure contagion. We first identify the chan-
nels through which shocks are usually propagated across markets. We estimate a
VAR-MGARCH-Baba–Engle–Kraft–Kroner (BEKK) model of financial interde-
pendence and identify the MGARCH residuals for each equation. The conditional
distributions of the stock exchange or exchange rate returns, s1,t = ln(s1,t) − ln(s1,t−1)
and s2,t = ln(s2,t) − ln(s2,t−1), generate the following joint process:

⎛ s1,t ⎞ ⎛ π 11 π 12 ⎞ ⎛ s1,t −1 ⎞ ⎛ u1,t ⎞

⎜⎝ ⎟⎠ = ⎜⎝ ⎟⎜ ⎟ +⎜ ⎟ (1)
s2,t π 21 π 22 ⎠ ⎝ s2,t −1 ⎠ ⎝ u2,t ⎠

with the following properties for the means and variances/covariances:

© 2015 John Wiley & Sons Ltd

66 Erdem Kilic and Veysel Ulusoy

⎡⎛ 0⎞ ⎛ σ 1,t σ 12,t ⎞ ⎤
2
⎛ u1,t ⎞
⎜⎝ I t − 1 ⎟ ~ t ⎢⎜ ⎟ , ⎜ ⎟
u2,t ⎠ ⎣⎝ 0⎠ ⎝ σ 21,t σ 22,t ⎠ ⎥⎦

where σ i2,t = a0,i ,i + a1,i ,i ε i2,t −1a1,i ,i + b1,i ,iσ i2,t −1b1,i ,i , σ1,j,t = a0,i,j + a1,i,iεi,t−1εj,t−1a1,j,j + b1,i,iσi,j,t−1b1,j,j
for i, j = 1, 2.
Equation (1) produces residuals, which are considered to exhibit ARCH-adjusted
effects, but still contain excessive volatility. In the second step, we use the GARCH
variance decomposition to determine excessive volatility for the relevant variable. At
the same time, this approach makes the outliers endogenously determinable and cor-
responds to a local endogenous shock in the relevant market. For this to be identified
we make the following proposition.

Proposition 1. It is anticipated that endogenous country-specific excessive volatility

creates international cross-country contagious effects.

The approach to identify abnormal excessive movements defined by equations (2a)

and (2b) is implemented using the variance equations from the GARCH variance
decomposition for the relevant variables, which are estimated in equation (1). The
changes in the time series are adjusted to three standard deviations. The estimated
parameter results are then plugged into equation (2a); values for each observation in
the time series are integrated according to this equation and calculated numerically.

σ i2,t = a0,i ,i + ∑ i − m a1,i ,i ε i2,t −1a1,i ,i + ∑ i = n b1,i ,iσ i2,t −1b1,i ,i

q p
(2a)

Excessive Volatilityα ( X ) = − inf { x ∈ℜ : P( X > δ ) ≤ 1 − α } , α = 99.7% (2b)

where δ = (σi,t)3σ.
The acquired results are the extreme movement benchmark values for each rel-
evant variable. They are compared with changes in the spreads in each period. In
each case in which an excess occurs, the dummy variable adopts the value 1 for this
period. This procedure is successively conducted for all periods. Finally, a series is
generated, which consists of the values 1 and 0. The newly generated series is
included in the previous MGARCH system. We then re-estimate the VAR-
MGARCH model of interdependence by including the dummy variables. The goal
is to identify periods of financial turbulence. Equation (1) is rearranged to develop a
test for excessive volatility:

⎛ s1,t ⎞ ⎛ π 11 π 12 ⎞ ⎛ s1,t −1 ⎞ ε
−1 ⎛ 1,t ⎞
⎜⎝ ⎟⎠ = ⎜⎝ ⎟⎠ ⎜⎝ ⎟⎠ + B ⎜⎝ ⎟⎠ (3)
s2,t π 21 π 22 s2,t −1 ε 2,t

where B is the matrix, defining the contemporaneous feedback between the spreads
and, thus, their interdependence. In conclusion, the residuals are structured by the
following dynamics:

⎛ ε 1,t ⎞ ⎛ ⎛ a11 a12 ⎞ ⎛ d1,t 0 ⎞ ⎞ ⎛ ε 1l ,t ⎞

⎜⎝ ⎟⎠ = ⎜⎝ I + ⎜⎝ ⎟⎜ ⎟⎟ .
ε 2,t a21 a22 ⎠ ⎝ 0 d2,t ⎠ ⎠ ⎜⎝ ε 2l ,t ⎟⎠

These residuals exhibit ARCH-effects and excessive movements in the variables.

The coefficients in the A matrix allow for the transmission process of excessive vola-

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 FINANCIAL CONTAGION IN ENDOGENOUS VOLATILE PERIODS 67

tility (contagion); the objective for them is to indicate how the propagation of finan-
cial shocks across countries is modified during periods of turmoil. Large residuals
(i.e. local shocks in the economic sense) are defined by the excessive volatility
benchmark approach and are identified by the dummy vector d = (d1,t/d2,t) with the
objective of filtering excessive volatility and abnormal events out of the residuals by
describing periods of market turbulence. Diagonal blocks of matrix A show the
extent to which the normal-time structural shocks are amplified within countries.
Diagonal blocks (of the D matrix) allow for transmission in the propagation of such
shocks across countries. Therefore, we can test the hypothesis that during crises, the
normal channels of interdependence are modified with VAR-MGARCH structure.

Hypothesis 1. H0 : aij = 0, for each i ≠ j, absence of transmission excessive volatility (no

contagion), H1 : aij > 0, for each i ≠ j, occurrence of transmission excessive volatility
(contagion).

The structural model is identified by the restriction that in each equation, the own
lagged dependent variable is sufficient for capturing structural dynamics.

⎛ s1,t ⎞ ⎛ γ 11 0 ⎞ ⎛ s1,t −1 ⎞ ⎛ 0 −β12 ⎞ ⎛ s1,t −1 ⎞ ⎛ ⎛ a11 a12 ⎞ ⎛ d1,t 0 ⎞ ⎞ ⎛ ε 1l ,t ⎞

⎜⎝ ⎟⎠ = ⎜⎝ ⎟⎜ ⎟ +⎜ ⎟⎠ ⎜⎝ ⎟⎠ + ⎜⎝ I + ⎜⎝ ⎟⎜ ⎟⎟
d2,t ⎠ ⎠ ⎜⎝ ε 2l ,t ⎟⎠
(4)
s2,t 0 γ 22 ⎠ ⎝ s2,t −1 ⎠ ⎝ −β 21 0 s2,t −1 a21 a22 ⎠ ⎝ 0

where β12, β21 determine interdependence, α12, α21 allow for contagious effects. The
parameters of the structural residual shocks follow the distribution:

⎛ ε 1,t ⎡⎛ 0⎞ ⎛ σ ε 1,t σ ε 12,t ⎞ ⎤

l
⎞
2

⎜⎝ l
ε 2 ,t
I t , 1 ⎟⎠ ~ t ⎢⎜⎝ 0⎟⎠ ⎜⎝ σ
, ⎟
σ ε22,t ⎠ ⎥⎦
⎣ ε 21,t

where σ ε2i ,t = aε 0,i ,i + aε 1,i ,i ε i2,t −1aε 1,i ,i + bε 1,i ,iσ ε2i ,t −1bε 1,i ,i , σεi,j,t = aε0,i,j + aε1,i,iεεi,t−1εεj,t−1aε1,j,j +
bε1,i,iσεi,j,t−1bε1,j,j for i, j = 1, 2.
The advantage of our approach is that it simultaneously estimates interdepend-
ence and particularly contagion. Our model holds up against the argument made by
Forbes and Rigobon (2002) that volatility-amplification increases during crisis
periods cause the calculated correlation coefficients of the crisis periods to increase.
Thus, in high volatility periods, the transmission process is modified and increases
the probability of bias in the estimation results; however, our model utilizes a full
sample approach that circumvents this criticism. Highly volatile periods, or volatility
breakdown effects, are endogenously determined and explicitly introduced into
the full sample model. Therefore, the applied model provides control over the tur-
bulent periods in terms of dummy variables. In other words, it can be argued
that the model explicitly knows the source of potential bias and provides control
over it.

Model Specifications
A trivariate MGARCH model is specified according to the methodology in the previ-
ous subsection to capture the selected stock exchange markets and foreign exchange
markets.8 The BEKK models in this class are built on the idea of direct generaliza-
tions of the univariate GARCH model of Bollerslev (1986). The general case of a
MGARCH-BEKK model is represented in equation (5).

© 2015 John Wiley & Sons Ltd

68 Erdem Kilic and Veysel Ulusoy

yt = B′ xt + ε t (5)

( ε t I t −1 ) ∼ f [0, H t ]

H t = g ( H t −1, H t − 2, … , ε t −1, ε t − 2, …)

where Bt is the return coefficient matrix, εt is the innovation process (residual) for the
conditional mean, Ht is the conditional variance–covariance matrix, f(·) is the density
function of the innovation process, g(·) is a function of lagged conditional variance–
covariance matrices and innovation processes.9
A trivariate MGARCH model allows a focused view on interdependence and con-
tagion relations with interdependent variable volatilities. For each country, the
foreign exchange market and the stock exchange market are introduced into a
trivariate VAR-MGARCH, which models the propagation of external, endogenously
determined shocks. The dummy variable in the D matrix block determines from
which market the contagious effect originates. The VAR-MGARCH models contain
two external markets, each of a different market type but from the same country, and
one domestic market, for which the external contagion effect is tested. For instance, if
the contagion originating from the DAX in US markets is analyzed, the model will
contain the following variables: DAX, German mark, US dollar or, alternatively, the
Dow Jones Index.10 The variables are iterated for all markets, and in each model, the
last equation contains the target markets (foreign exchange rate market or stock
exchange rate market) (see equation 6).

⎛ 1 −β12 −β13 ⎞ ⎛ stock ex ⎞ ⎛ γ 11 0 0 ⎞ ⎛ stock ex t −1 ⎞

⎜ −β 21 1 −β 23 ⎟ ⎜ exch ex ⎟ = ⎜ 0 γ 22 0 ⎟ ⎜ exch t −1 ⎟
ex
⎜ ⎟⎜ ⎟ ⎜ ⎟⎜ ⎟
⎝ −β 31 −β 32 1 ⎠ ⎝ variableen ⎠ ⎝ 0 0 γ 33 ⎠ ⎝ variableent −1 ⎠

⎛ ⎛ a11 a12 a13 ⎞ ⎛ d1,t 0 0 ⎞ ⎞ ⎛ ε 1′,t ⎞

+ ⎜ I + ⎜ a21 a22 a23 ⎟ ⎜ 0 d2,t 0 ⎟ ⎟ ⎜ ε 2′ ,t ⎟ (6)
⎜ ⎜ ⎟⎜ ⎟⎟ ⎜ ⎟
⎝ ⎝ a31 a32 a33 ⎠ ⎝ 0 0 d3,t ⎠ ⎠ ⎝ ε 3′,t ⎠

( ε t I t −1 ) ∼ t [0, H t ]

where Ht follows the properties as in equation (4).

Each exogenous shock is determined according to the residual of the related vari-
able, which is determined using a vector autoregressive structure consisting of the rel-
evant variables as described in equation (6).11 Consequently, we utilize a diagonal
BEKK estimation to account for the cross-correlations of the endogenous variables.12

4. Propagation of Excessive Volatility

Macro-level models with more markets would show the most dominant interdepend-
ence and contagion cases. However, multicollinearity in the estimated coefficients
could be a potential drawback in such large models. Therefore, we construct extracted
micro-level models with the purpose of achieving more accurate results for the com-
position of interdependence and contagion. Nonetheless, these models will surely
suffer from information loss. According to our model specification, interaction in both
market types can be investigated (see equation 6). The results for these micro-level

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 FINANCIAL CONTAGION IN ENDOGENOUS VOLATILE PERIODS 69

models are presented in Tables 1a–n (included with this article online as Supporting
Information as detailed at the end of this paper—also available at http://rdmklc
.files.wordpress.com/2013/10/appendix_pdf).
For leading financial centers, contagion cases in foreign exchange markets are
greater in number than in stock exchange markets. A potential reason for this trend
is that leading currencies serve as the main transaction units, as they fulfill the func-
tion of intermediation in international transactions. Therefore, currencies are always
subject to speculative intentions and, thus, accommodate for the risk of extreme
fluctuation.
In the case of China and the emerging market of Turkey, foreign exchange markets
are more affected by contagion cases than stock exchanges. An explanation may be
provided by discontinuities in trade as in FDIs in emerging markets, as they mostly
originate from multinational corporate decisions and, therefore, from a channel of
potential turbulence propagation.
Further considerations show that trade partners are clearly originators of conta-
gion, particularly in emerging markets. Stock exchange markets as contagion sources
follow the analogy of corresponding FDI partners; that is, close FDI relations expose
the risk of contagion for stock exchange markets. Eichler and Maltritz (2011) state
that financially liberalized emerging economies with high inflows of portfolio capital
invested in their booming stock markets are particularly prone to stock market-
induced currency crises, whereas countries with low capital inflows and stagnating or
falling stock markets are not.
In general, it can be observed that foreign exchange markets are more exposed to
contagion. Germany and Mexico follow an exceptional pattern. Although Turkey is
subordinated in trade and FDIs, it creates contagion in both market types.

5. Discussion
As mentioned in the previous sections, the phenomena of interdependence and conta-
gion relationships must be analyzed with various real economic or financial linkages,
such as (commodity) trade, FDI, and speculative cash flows.
It is apparent that markets with a high contagion-interdependence ratio have
undiversified FDI partnership relations and very dominant trade partners. The
ability of markets to take global financial sidesteps is restricted by the lack of diver-
sification of interdependencies and incompleteness of the markets in the sense of
Allen and Gale (2000). Analogous to Kenen’s (1969) argument that diversified
industrial structures in each country reduce the size of aggregate country-specific
shocks in the context of optimal currency areas, diversified trade and capital inflow
structures reduce the amount of exposure to contagion.13 In other words, the reac-
tion flexibility to evade shocks increases as the degree of diversification in trade and
capital flows increases. In this way, an asymmetric propagation of contagion
is stimulated. Although interconnectedness in financial markets suggests mutually
exciting transmission processes, the reverse propagation originating from
smaller markets does not occur owing to a lack of diversification in international
linkages.
Germany’s results must be examined with respect to the dynamics of the common
currency area. Exchange rates exhibit excessive volatility and are a source of great
macroeconomic volatility, especially in small, open economies. In this world it is ben-
eficial for small, open economies that allow the free movement of capital to fix their
exchange rates as a way to avoid the disruptive macroeconomic effects of floating

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70 Erdem Kilic and Veysel Ulusoy

exchange rates.14 The wide range of commodity trade and industrial and financial
linkages within the Euro area creates a buffer zone for cross-border contagion in the
foreign exchange market, despite the large variety of international capital flows from
outside the monetary area.15
One market that is most exposed to contagion is the UK. Financial openness
towards China and close relationships to the USA and the Euro area open substantial
channels for contagion transmission. Deep connectedness of economic markets in
financial issues and commodity trade appears to open new transmission channels for
external shocks.
In the case of China, two aspects reflect its low size of the contagion parameters.
The yuan has synthetically been suppressed in value to gain competitiveness for the
Chinese economy in international trade markets by the conduction of a managed
floating exchange rate regime. As a result of the fixed value and its low variance, the
yuan does not respond to external spillover effects. In addition to contagion, insensi-
tiveness in the case of interdependence is observable. Keeping China’s leadership in
mind, the inclusion of the Asian markets would surely offer more accurate explana-
tions.16 Another aspect is the powerful position of the Chinese economy as one of the
world’s largest economies in industrial production and GDP. Large diversification in
industrial production delivers another explanation for the robust position against con-
tagion exposure.
Japanese markets reflect the robust stance of its economy. Despite the fact that
interdependence is low, the contagion ratio is high. As the world’s third largest
economy, it plays a price-setter role in the global markets. Furthermore, apart from
being subject to contagion, Japan is a major contagion creator. Turbulence in the
Japanese markets spills over to other globally linked markets, which is reflected in the
high significance of the results. Financial sector openness of the Japanese economy
creates propagation channels of contagion from outside. The low interdependence
cases reflect the high scale effect of the industrial production.
The results for the Turkish markets reflect narrow relationships in the economy,
particularly concerning EU trade partners. European countries as dominant trade
partners can be regarded as a weakness toward significant interdependence. Simi-
larly, concerning FDIs, Turkey’s dominant interdependence with the USA and
Europe generates a further risky position regarding exposure to contagion, meaning
that Turkey is linked to two powerful economic blocs, which open two substantial
channels of financial shock transmission and reduce the flexibility in avoiding poten-
tial shocks. The contagion case, which is originating from the Japanese yen, can be
explained by indirect effects through the channels of similar FDI partners.
The American markets exhibit a low order of interdependence (including weak
interdependence) but a relatively high contagion ratio. A potential explanation can be
given by the widely spread international FDI partners and trade partners. However, it
can be observed that, with exception for the DAX and the UK sterling, all other
parameters are relatively low in both market types. As in the case of Japan, the US
economy dominates international capital markets. Thus, the opposite direction of
contagion prevails; namely, US markets are one of the primary sources of contagious
effects with asymmetric transmission properties.
The high order of contagion in Mexican markets reflects their exposure to financial
markets. The dominant role of the USA as Mexico’s primary trade and FDI partner
best illustrates the case for contagion exposure with insufficient diversification in com-
modity and capital flows. The contagion cases in the results indicate indirect effect
through trade partners of the USA.

© 2015 John Wiley & Sons Ltd

 FINANCIAL CONTAGION IN ENDOGENOUS VOLATILE PERIODS 71

In the case of contagion without any observable financial interdependence, specula-

tive capital flows, beside FDIs and trade are to be considered as explanatory factors in
contagion. The interdependences originating from stock markets in the models indi-
cate that deep linkages among stock markets prevail on further consideration. Signifi-
cant turmoil in cross-border stock exchange markets is anticipated to have
transmission effects on the domestic market owing to interdependent relations. The
coincidence of contagion and interdependence cases in the models, which originate
from stock markets, can be interpreted as a case of structurally anticipated shock
transmission.
Interdependence in foreign exchange markets is globally constructed. Turbulence,
or excessive behavior in exchange rates, spills over more widely as a global phenom-
enon, sometimes without any obvious fundamental economic explanation. An impor-
tant consideration is that turbulence occurs endogenously in the domestic markets,
according to our model. This domestic excessive behavior is instantaneously transmit-
ted internationally. The risk that the foreign market has not anticipated domestic tur-
bulence cannot be neglected.17 Preparedness of foreign markets against domestic
shocks is central to contagion propagation. The circumstances under which the shock
occurs define the extent to which the shocks can be absorbed; that is, the financial
system and the economic stance are important indicators under this consideration.

6. Conclusion
In this article, we analyze the transmission mechanisms of endogenous excessive vola-
tility to another international financial market. Central patterns in the obtained
results can be observed when considering the transmission of contagion effects.
Interdependence between two centers is a central phenomenon. If a country has
strong relations with two dominant central financial markets, its markets suffer
severely from contagion. In this situation, when the foreign economic surroundings
(i.e. foreign linkages) do not build a buffer zone, the lack of domestic real economic
activities/production is more apparent. In the contagion-related discourse, these types
of markets are, roughly speaking, tight on edge; consequently, fundamental propaga-
tion channels of turbulence are opened.
Analogous to Kenen’s argument, diversification in both financial and real economic
linkages is another key aspect of the results. FDIs and trade diversification loosen the
tension of direct interdependence and of unilateral dependence for emerging
markets. Consequently, exposure to contagion is higher without diversification in
partner markets. Another interesting pattern is that occurrence of contagious effects
in stock exchange markets are higher than in stock exchange markets. Indisputably,
the role of volatility transmission from speculative flows in the foreign exchange
markets and the intensity of market transactions are to be addressed as explanatory
reasons. Thus, the foreign exchange markets are able to impose dynamics originating
from trade flows and further macroeconomic developments into the stock exchange
markets.
Central financial markets with high production levels and high financial openness
levels exhibit price-setter behavior; namely, they propagate a source of contagion
with global impact, and simultaneously among each other. In this case, diversification
is not as important as it is in small adjunct market places, which exhibit an asymmetry
of financial contagion transmission.
Contagion can conclusively be perceived as a phenomenon of international capital
flow dynamics, acceleration of capital and intensity of capital markets. However, real

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72 Erdem Kilic and Veysel Ulusoy

economic output and a robust financial system stem the effects of contagion. The
financial architecture of control and monitoring systems for capital flows, regulation
of international financial markets, and basic rules of coherence with domestic finan-
cial systems should be considered for the structural absorption of unanticipated tur-
bulence in international markets.

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Notes
1. Chui and Taylor (2002, p. 566).
2. See Corsetti et al. (2005) and Billio and Caporin (2010) for an illustration of the concept of
contagion. For a comprehensive literature survey on testing for empirical measurements of
financial contagion, see Pericoli and Sbracia (2003).
3. See Bredin et al. (2009) for an illustrative use of the VAR-GARCH-M approach to investi-
gate dynamic macroeconomic relationships.
4. Allen and Carletti (2008, p. 2).
5. Some illustrative examples include the Mexico Peso crisis (1994), the Asian financial crisis
(1997), and the currency crisis in Turkey (2001).
6. See Krugman and Venables (1995), Rodrik (1997) and Poon et al. (2000) for descriptions of
trade, FDI and globalization discourses.
7. The conversion after 2000 is conducted based on the official rates of the European Central
Bank.
8. Stationarity of the series is tested by conventional tests, such as serial correlograms and aug-
mented Dickey–Fuller unit root tests.
9. See Engle and Kroner (1995), Xekalaki and Degiannakis (2010) for detailed illustration of
the estimation procedure.
10. Applying this procedure, we estimate a total of approximately 196 VAR-MGARCH
models.
11. Normality and heteroskedasticity in the VAR-MGARCH models are tested by conven-
tional tests, such as serial correlation Langrange multiplier tests, Jarque–Bera normality tests,

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74 Erdem Kilic and Veysel Ulusoy

White heteroskedasticity tests and stability tests of coefficients. Based on several these statisti-
cal tests, we prefer t-distribution for all models. Owing to space limitations, we do not present
the test results and instead focus on the results of the models. They are, however, available
upon request.
12. The optimal number of lags and the correct specifications for the trivariate VAR-GARCH
model in equation (6) is chosen on the basis of some criteria, such as sample cross correlations
and Portmanteau tests, Akaike and Schwarz information criteria. The specific results can be
presented upon request.
13. Further details related to diversification and the effects of country-specific shocks are pro-
vided by Frankel and Rose (1998). Based on a test of a country’s vulnerability to industry-
specific shocks, they observe that closer trade links tend to initiate more tightly correlated
business cycles.
14. De Grauwe and Schnabl (2008, p. 546).
15. This result is one of the main motivations for establishing a monetary union, as in the case
of the Euro. A buffer zone functions to soften the excessive or speculative behavior of capital
flows. In the case of Germany, this goal seems to be achieved, while keeping in mind the posi-
tion of the UK, which has a higher rate of contagious effects.
16. Compare McKinnon and Schnabl (2004) for reflections on the increasingly integrated East
Asian economy.
17. See Escaleras and Thomakos (2008) for similar results.

Supporting Information
Additional Supporting Information may be found in the online version of this article
at the publisher’s web-site:
Appendix S1. Evidence for Financial Contagion in Endogenous Volatile Periods

© 2015 John Wiley & Sons Ltd