The Normal, the Fat-Tailed, and the Contagious: Modeling Changes in Emerging Market Bond Spreads
Center on Social and Economic Dynamics Working Paper No. 32
44 Pages Posted: 9 Nov 2007
Date Written: June 2003
We examine the statistical properties of daily changes in emerging market bond spreads over US treasuries, and simulate an agent-based model to attempt to replicate those properties. The actual data indicate that changes in spreads: 1) are definitely not normally distributed, exhibiting much fatter tails; 2) are serially correlated, suggesting deviation from market efficiency; and 3) exhibit excessive co-movement, suggesting contagion. A simple model of interacting traders produces alternating booms and crashes, as in reality, but is not capable of producing fat-tailed distributions or contagion. We focus on an extended model with market makers whose bid/asked spreads widen with increased volatility and the size of their inventory. This model highlights the role of liquidity (or lack of it) in explaining large rate movements and contagion.
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