Impact of US Financial Crisis (or a shock to US stock market) on

the National Stock Returns of Other Economies

Motivation

 Documentary “too big to[let] fail”; which chronicles the financial meltdown of 2008 and centers on Treasury
Secretary Henry Paulson.
 Bankruptcy of 4rh largest investment bank of USA, Lehman brothers and the downfall of the financial crisis
afterword.
 Fed and Treasury decided not to rescue Lehman, but that hit the mass confidence hard and stock market goes into
freefall.
 Insurance firm AIG (American International Group) also begins to fail. French PM warns Paulson (the crisis is
affecting Europe as well). Unlike Lehman, the Treasury rescues AIG with an $85 billion loan, deeming it “too big
to[let] fail”.
 For recovery, Troubled Asset Relief Program (TARP) was created (direct capital injection-worth $125 billion, doubt
about the use of the fund).

This got me interested in working on the financial crisis and its impact on other countries with well developed stock
market. I want to do a time series application to see the interdependence between the US stock returns and other
advanced countries.
 Background
How global financial crisis began?

 It was triggered by the collapse of the U.S. housing market (investors doubt about the true value of securities
built off real estate collateral, security prices fell, bank doubting each other’s stability, liquidity crisis hit).
 This caused a crisis in the financial sector, as many banks and financial institutions had invested heavily in
mortgage-backed securities (Bear Stearns, Lehman bothers, etc).
 It quickly spread to other parts of the world, as financial institutions around the globe are interconnected by
trading relationships.

Why it is important to study spillover effects on national stock returns?

 When there is a shock or disturbance in one market, quickly spread to other markets through various
channels, such as trade, capital flows, and investor confidence.
 This can lead to increased volatility and instability in financial markets with significant economic and
social consequences (job loss, people losing their savings, lower spending and so forth).
Increasing interconnectedness between the advanced countries and the US
U.S. GDP is slightly more than one-fifth of the world total and U.S. stock market capitalization is about one-
third of world market capitalization. The United States is also the largest importer in the world. This means that
a decline in U.S. GDP and U.S. stock market capitalization can adversely affect other countries through various
trade and financial linkages (Hwang, E. et al. 2013).
An adverse shock in one large country can be transmitted internationally through various channels
involving import/export markets and capital markets as well as through changes in exchange rates
and commodity prices. The magnitude of the effect of a shock will depend to a large degree on the
strength of linkages between countries.

On average, both the shares of their

total exports and imports to the US
have slightly decreased over time.
Existing Literature
There’s a vast literature on US financial crisis and some on its impact on other countries both advances
and emerging economics. These tests have been utilized to examine stock market interdependence,
financial market integration, the transmission of shocks across national borders, and financial
contagion.

• Since 1980s, the co-movements have been increasing. So, stock market linkages may be an
appropriate channel to focus on in examining the transmission of shocks associated with the collapse
of the U.S. mortgage and credit markets and corresponding spillover effects to other countries around
the world (Angkinand, A.P. et al. 2009).
• Using the dynamic conditional correlations (DCC) of the daily stock returns of 10 emerging
economies in comparison with those of the US for the period of 2006–2010, Hwang, E. et al. (2013)
studies the determinants of co-movements and find that countries face different phases of crisis
transmission mechanisms compared to US.
• Bertero and Mayer (1990) (for 23 countries) and Lee and Kim (1993) (for 12 countries) find evidence that
correlation coefficients for stock returns between the United States and the other countries significantly
increased after the 1987 crash.
Research Question/Objective

To account for the limitation of methodology used in the literature, Angkinand, A.P. et al. (2009) examines the
degree of interdependence between national stock market returns for 17 advanced economies and the United
States for various sub-periods from January 1973 to February 2009.

For the research paper for this course, I am reproducing their results and extending it by increasing the dataset
to 2022. The paper aims to answer two questions :
What is the degree of interdependence between national stock market returns for 17 advanced economies and
the United States?
What are the spillover effects from a shock to U.S. stock market returns to the advanced economies, particularly
in the pre- and post-turmoil periods that characterize the U.S. financial crisis?

Extending the dataset to 14 more years I want to assess whether there have been any broad changes in the
degree of interdependence after the recovery of the crisis.
Methodology

They use time-series techniques including both single equation (OLS & GMM) and system approaches
(structural vector autoregressive process, SVAR).

The univariate approach is used to test for the degree of interdependence and co-movement, whereas the system
approach is used to assess the magnitude of any spillover effects (dynamic effects of a structural shock in U.S.
stock returns that occurs on the stock returns in other countries) that might exist.

The data consists of weekly and monthly national stock market returns for the 17 advanced economies in the
sample from January 1973 to February 2009. The data was obtained from Thomson Datastream.

I will try to access the data from the same source if that is publicly available otherwise will try to see if they are
available in other sources. I will apply the same methodology.
Results

The degree of interdependence and spillover effects were greatest after the emergence of the U.S. subprime
mortgage meltdown in the summer of 2007, and even more so after the collapse of Lehman Brothers in
September 2008.

The empirical results indicate varying degrees of interdependence in the earlier decades. However, the results
become fairly uniform across all the countries after the emergence of the U.S. financial crisis.

The paper also finds that the spillover effects were asymmetric, with the U.S. having a greater impact on other
countries than vice versa. These findings suggest that investors may not benefit from portfolio diversification
(practice of spreading investments into mix of assets to limit exposure to any single asset risk) when
diversifying across a geographically diverse group of countries during times of financial crisis.
References

Angkinand, A.P., Barth, J.R., and Kim, H. (2009). Spillover effects from the U.S. financial crisis: Some time-
series evidence from national stock returns. The financial and Economic Crises: An International Perspective
(pp. 123-161). Edward Elgar Publishing.

Baily, M.N. and Elliott, D.J (2009).The US Financial and Economic Crisis: Where Does It Stand and Where Do
We Go From Here? The Initiative on Business and Public Policy (pp. 110-136).

Long, W. et al. (2012).Impact of US financial crisis on different countries: based on the method of functional
analysis of variance. Procedia Computer Science 9 (pp. 1292 – 1298).

Hwang, E. et al. (2013). Determinants of stock market co-movements among US and emerging economies
during the US financial crisis. Economic Modelling 35 (pp. 338–348).

Chen, Q. (2016). Financial crisis, US unconventional monetary policy and international spillovers. Journal of
International Money and Finance 67 (pp. 62–81).
Extra

• I changed my topic three times for this project. Friday night watched a documentary “too big to[let] fail”;
which chronicles the financial meltdown of 2008 and centers on Treasury Secretary Henry Paulson. It is
based on the bankruptcy of 4rh largest investment bank of USA, Lehman brothers and the downfall of the
financial crisis afterword. Fed and Treasury decided not to rescue Lehman, but that hit the mass confidence
hard and stock market goes into freefall.
• Meanwhile, insurance firm AIG (American International Group) also begins to fail. French PM warns
Paulson that he must not allow AIG to fail, as the crisis is affecting Europe as well. Unlike Lehman, the
Treasury rescues AIG with an $85 billion loan, deeming it “too big to[let] fail”.
• For recovery, Troubled Asset Relief Program (TARP) was created for mandatory direct capital injection to
leading 9 banks in the US (worth of $125 billion), but there is doubt that money was used to restore credit for
ordinary consumers rather it was used to hand out large bonuses to executives.
• Watching this documentary got me interested in working on the financial crisis and its impact on other
countries with well developed stock market. I want to do a time series application to see the interdependence
between the US stock returns and other advanced countries.
• Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's
outstanding common shares owned by stockholders.
• Market capitalization is equal to the market price per common share multiplied by the number of common
shares outstanding.