INTERDEPENDENCE AND CONTAGION

AMONG GLOBAL EQUITY MARKETS

HISTORICAL REVIEW AND EMPIRICAL EVIDENCES
 Analysis of Interdependence
• Seminal work of Grubel (1968): Portfolio risk can be minimized by
international portfolio diversification.
• International investors are generally interested in global stock
market linkages wherein they try to figure out a combination of
international stocks to create the best possible portfolio
combination.
• Well diversified portfolio imply lower risk (Dajcman, 2012)
• Lower risks from international portfolio diversification depends on
low correlation among global equity markets (Grubel and Fadner,
1971)
• This implies that increased comovements between returns of global
equity markets diminishes the benefit of diversification (Ling and
Dhesi, 2010)
• Dynamic changes in comovements and interdependence among stock
returns implies evolving correlation structure (in time) among
markets (Engle, 2002)
• Hence, market observers and investors should continuously
monitor asset returns to identify changes in the structure of
correlation as it will have an effect on portfolio diversification.
• Interdependence analysis for IPD : No linkages between returns
of Germany, Japan, UK, USA. Scope for IPD (Agmon, 1972;
Lassard,1973; Solnik, 1974)
• However after 1987 crash, strong interdependence found . No
possibility of IPD (Bertera and Mayer,1990; Eun and Shim, 1989;
Von Furstenberg and Jeon, 1990)
• Since then mixed results concerning interdependence and IPD.
• Benefit of IPD for investors in developing countries investing
abroad (Dressen and Leaven, 2007)
• Investors background: Underdiversified portfolio mostly held by
novice and less-sophisticated investors. Investors with superior
information deliberately underdiversified (Groetzmann and
Kumar, 2008)
• A wide number of studies out there.
• Correlation and Cross correlation structures widely studied in literature.

• Information from the trading hours of one market has a global impact on
returns of other market (Lin et al., 1994)

• Similar conclusion in the study of New York, Tokyo and London markets
(Hamao et al., 1990)

• Correlation between US and other markets higher during high variance

periods (Ramachand and Susmel, 1997; Andersen et al., 2001), reducing
benefit of IPD.

• Complex linkages of volatilities of far east markets and not just the flow
from the US to Eastern markets (Hu et al., 1997; Wei et al., 1995,
Miyakoshi, 2003)

• Progressive integration of US, UK, Germany and Japan (Moranna and

Boratti, 2008)
• Policy implications: Less interdependence,
therefore investors should include stocks from
these markets in their portfolio, as international
portfolio diversification improves the risk factor.

• Investors should be cautious while including

stocks from Asian and East Asian Markets as
interdependence exists from medium to long run
time horizons.
• Contagion: Transmission of shocks between two unrelated
markets, with no proper linkages.
• Forbes and Rigobon (2002): Shift contagion- when shock to one
country, due to financial crisis, leads to substantial rise in cross-
country linkages. There will be a major shift in inter-market
linkages.
• Shift-contagion related inter-market linkages can be measured
using changes in returns correlation, probability of shocks
arising out of speculation, magnitude of volatility transmission.
• Majority of empirical literature rely on test of asset returns
correlation between markets.
• Substantial rise in cross-market correlation of asset returns after
a shock.
• Various mechanisms of shock transmission between countries.
• Spread of financial disturbance from one market to another, or
contagion, can be observed through downward comovement in
asset prices (Claessens et al., 2001).
• But comovements between historically interdependent countries
cannot be termed as contagion, as it reflects already existing
interdependence. It is called fundamental based contagion.
• On the contrary, crisis can be propagated via non-fundamental
channels where contagion occurs independently of fundamentals
and market interdependence.
• Can be triggered by the behaviour of investors who suddenly
withdraw investments from many countries. Herd behaviour.
• Uninformed speculations, panic, loss of confidence and decisions
based on imperfect information. These are non-fundamental
channels.
• One of the fundamental channels: Common global shocks-changes
in commodity prices and major restructuring of advanced economies
can trigger a crisis in emerging economies. Calvo and
Reinhart(1996).
• Local shocks- arising out of crisis in one country. Influences
economic fundamentals in other markets.
• Financial linkages: A crisis in one market will impact other market.
Finance route plays a role via reduction in FDI and trade credit.
• Transmission of shocks can be attributed to herd behaviour of
investors. Information possessed by investors play an important
role in generating herd behaviour.
• Not all investors are well informed.
• Investors who are well informed specialize and operate in a
particular market.
• They periodically liquidate their assets to meet other demands or
reformulate portfolios.
• Can give wrong signal to uninformed investors who interpret this
behaviour as indication of poor returns, thereby generating herding.
• Asymmetry in investors information creates herding, false alarm.
(Bayoumi et al., 2007)
• King and Wadhwani (1990): contagion happens due to the
information inferring behaviour of rational agents.
• Rational investors who wrongly infer events in other markets generate
a transmission channel, where mistakes in one markets are transmitted
to other.
• Calvo and Mendoza( 1998): Less informed investors, who find
gathering information costly, will mimic the behaviour of informed
investors.
• However, they end up mimicking mistakes too due to herding
behaviour. A bad decision by informed investors, which puts them in a
bad equilibrium state, will similarly move uninformed investor to that
state.
• Information cascade is generated which drives the uninformed
investors to ignore their own information set and follow the
behaviour of informed investors. (Wermers, 1995).
• Masson (1998): Investors’ behaviour based on expectations generates
a state of multiple equilibrium, both good and bad. Crisis transmission
drives the market to a bad state, causing contagion.
• Multiple equilibrium model of contagion: Expectations play
a key role in driving the market towards turmoil.
• Masson (1998): crisis in one market synchronises the
expectations of investors in other market, causing equilibrium
to shift from good to bad.
• This shift in equilibrium is driven by changes in investors’
expectations and not by real factors.
• Liquidity shocks play an important role in crisis propagation.
• Investors experience a reduction in liquidity after crisis in one
country. This could compel them to sell assets in another
markets to satisfy margin calls, fulfil regulatory requirements
etc.
• Drazen (1992). Political factors led to contagion in 1992 UK
exchange rate crisis.
• Crisis-contingent theories: Multiple equilibrium channel,
liquidity shocks channel and political channel.
• Theories that illustrate how channel of shock propagation does
not lead to shift contagion fall under non-crisis contingent
theories of contagion. Channels of transmission are same during
both stable and crisis period.
• Highly interdependent countries with proper financial market
integration experience high cross-correlation after a shock.
Reflects already existing channels of transmission.
• These channels are known as real linkages. Depends on
economic fundamentals.
• Eg. Trade linkages, coordination of economic policies, global
shocks, revaluation of other countries’ mistakes.
• Trade: devaluation hurts its trading partner.
• Coordinated policy responses: Country can imitate other
country’s policy response to a shock.
• Bad economic news: Propagation of information from one market
to another (Kiyotaki and Moore, 2003; Kaminsky et al., 2003)
• Flight-to-quality: Liquidity shocks form an
important channel. Liquidity crunch arises via a
flight–to-quality where loss incurring investors
sell their assets and opt for safer options.
Brunnermeier and Pedersen (2009).
• Risk premium channel: shock in one market
increases the risk premium in another market
(Vayanos, 2004; Acharya and Pedersen, 2005;
Longstaff, 2008).
 Measurement
• Contagion detected if change in correlation
among two markets between pre-crisis and post-
crisis period is statistically significant.