Theories of Contagion

Theories of Contagion

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Inhaltsangabe:Abstract: In recent years academics and policy makers have become more and more interested in the phenomenon of contagion, a concept involving the transmission of a financial crisis from one country to one or more other countries. During the 1990s world capital markets witnessed a number of financial crises. In 1992 the Exchange Rate Mechanism (ERM) crisis hit the European continent. Several countries in Latin America have been rocked during the 1994-95 Tequila crisis, and the Asian Flu spread through East Asian countries in 1997-98 with dramatic social implications. Later in 1998 the famous hedge fund Long Term Capital Management (LTCM) had to file for bankruptcy and the Russian debt failure shocked international capital markets and increased volatility on a global scale. The crisis spread to as far as Brazil in early 1999 and developed markets have become victims as well. The question asked by academics and policy makers is how countries should behave in order to avoid contagion. To answer this question it is necessary to understand the different channels of contagion in greater detail and how a crisis can be transmitted from one country to another. The objective of this paper is to highlight those channels and to present a number of models and theories of contagion, which have recently been developed by academics. In general, there are several strands of theories in the literature that try to explain the transmission of crises. During the mid and late 1990s fundamental-based contagion and spillovers became popular among researchers and policy makers. Furthermore, financial linkages have been known to contribute to contagion. In contrast, in recent years, portfolio flows of international investors moved into the focus of academics. The advocates of fundamental-based contagion and spillovers argue that trade linkages between countries are responsible for contagion. For instance, a devaluation of a country's currency may lead to a negative change in fundamentals of its trading partners. On the other hand, contagion due to financial linkages is mainly explained by the fact that countries share the same banks and therefore have common creditors. A crisis in one country then leads to a deteriorating balance sheet of those common creditors. This in turn may force banks to withdraw money out of other countries in order to avoid further losses, a fact that leads to contagious sellouts. The role of international portfolio flows, which is at the core of this paper, has become increasingly important in recent years, mainly due to the substantial progress in globalization. International financial markets became increasingly integrated and significant changes in international portfolio flows can easily lead to contagious sellouts and the transmission of crises on a global scale. Compared to other explanations of contagion, these theories abstract from the fact that countries must have fundamental linkages of any kind or that they engage in bilateral or third-party trade. The paper is divided into four parts. Part I provides an overview. The idea of contagion will be defined in section one and the transmission of crises based on fundamentals and spillovers will be introduced in section two. Part II through IV builds the heart of this paper. These parts offer a detailed analysis of various theories of contagion based on international portfolio flows, which have been discussed recently in the literature. Part II is comprised of some basic applications. The analysis starts in section three with an introduction to herd behavior and, more specifically, to information cascades. Even though information cascades are not directly a theory of contagion with respect to international portfolio flows, this concept can be viewed as relevant as it may explain how herds occur, which in turn can lead to changes in international portfolios. An application of basic principles of portfolio diversification will be at the heart of section four. It will be demonstrated how shocks to an asset's volatility or to equity capital available to an investor will influence international portfolio diversification. Part III deals with information asymmetries and contains two different models. The analysis starts with an introduction to information asymmetries and their influence on investment decisions in section five. There will be an illustration of a rational investor panic that is not justifiable by deteriorating fundamentals but is simply due to a particular type of herding. In section six, the second model then introduces the method of cross-hedging, which is also known as cross-market re-balancing. This theory is based on classic asset pricing models and illustrates, using examples, how contagion can occur due to portfolio re-balancing processes. Part IV finally discusses the concepts of risk aversion and wealth effects. In section seven investors' risk aversion and the compensation schemes of fund managers will be used to demonstrate the concepts of benchmark tracking and momentum trading. This behavior pattern can lead to portfolio re-allocations and may further step up the transmission of financial crises. A basic concept of portfolio linkages is used in section eight to introduce the effects of a change in investors' wealth and in their aversion to risk. This concept will be part of a model that will also be discussed in section nine. It will explain how investors are influenced by the decision-making process of other investors. This influence may then lead to a financial crisis where every investor rationally pulls out of a country. The model avoids the problem of multiple equilibria as it is known from traditional second-generation models of balance-of-payments crises. Instead, the model will always provide a unique equilibrium. The paper ends with some summarizing and concluding remarks. The previously discussed theories will be analyzed as a whole. Various proofs are included in appendix A through D in order to keep the paper as readable as possible. Table of contents: INDEX OF FIGURESIV INDEX OF TABLESV INDEX OF SYMBOLSVI INTRODUCTION1 PART IOVERVIEW3 1.DEFINING CONTAGION3 2.SPILLOVER EFFECTS AND FINANCIAL LINKAGES4 2.1BILATERAL AND THIRD PARTY TRADE4 2.2THE COMMON BANK LENDER / COMMON CREDITOR EFFECT6 PART IIBASIC APPLICATIONS8 3.HERD BEHAVIOR AND INFORMATION CASCADES8 3.1DEFINING HERD BEHAVIOR AND INFORMATION CASCADES8 3.2A BASIC MODEL OF INFORMATION CASCADES9 4.PORTFOLIO DIVERSIFICATION AND OPTIMIZATION14 4.1PORTFOLIO MANAGEMENT RULES14 4.2VOLATILITY EVENTS16 4.3CAPITAL EVENTS17 PART IIIINFORMATION ASYMMETRIES21 5.SIGNAL-EXTRACTION PROBLEMS AND INVESTOR PANICS21 5.1THE EMERGENCE OF INFORMATION ASYMMETRIES21 5.2THE MODELS22 5.3RATIONAL PANICS DUE TO INFORMATION ASYMMETRIES24 6.CROSS-MARKET RE-BALANCING AND CROSS-HEDGING25 6.1THE SET UP OF THE GENERAL EQUILIBRIUM MODEL25 6.2THE CROSS-MARKET RE-BALANCING CHANNEL OF CONTAGION27 6.3ON THE SEVERITY OF CONTAGION29 PART IVWEALTH EFFECTS AND RISK AVERSION32 7.BENCHMARK TRACKING AND RISK AVERSION32 7.1MODEL ASSUMPTIONS32 7.2DEMAND33 7.3INELASTIC SUPPLY34 7.4ELASTIC SUPPLY36 8.PORTFOLIO LINKAGES38 8.1THE CHAIN STRUCTURE39 8.2CONTAGION40 9.WEALTH EFFECTS IN A UNIQUE EQUILIBRIUM MODEL42 9.1THE MODEL'S ASSUMPTIONS43 9.2UNIQUE EQUILIBRIUM IN THE MODEL45 9.3THE WEALTH EFFECT, CONTAGION, AND CORRELATION49 9.4REAL-WORLD APPLICATION AND EMPIRICAL EVIDENCE52 SUMMARY a CONCLUSION54 REFERENCES57 APPENDIX APROOF OF EQUATION (3.3)62 APPENDIX BPROOF OF EQUATION (3.5) AND (3.6)63 APPENDIX CPROOF OF EQUATION (5.7)67 APPENDIX DPROOF OF EQUATION (7.22)68 ErklAcrung73The Market for aquot;Lemonsaquot;: Quality Uncertainty and the Market Mechanism. ... 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Title:Theories of Contagion
Author: Andreas Vester - 2006-10-01

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