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

See all articles by Paul R. Masson

Paul R. Masson

International Monetary Fund (IMF) - Research Department; The Brookings Institution

Date Written: June 2003

Abstract

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.

Suggested Citation

Masson, Paul R., The Normal, the Fat-Tailed, and the Contagious: Modeling Changes in Emerging Market Bond Spreads (June 2003). Center on Social and Economic Dynamics Working Paper No. 32, Available at SSRN: https://ssrn.com/abstract=1028085 or http://dx.doi.org/10.2139/ssrn.1028085

Paul R. Masson (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

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The Brookings Institution ( email )

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