Financial Contagion Risk and the Stochastic Discount Factor

89 Pages Posted: 21 Mar 2014 Last revised: 1 Mar 2017

See all articles by Louis R. Piccotti

Louis R. Piccotti

Oklahoma State University - Stillwater - Spears School of Business

Date Written: November 15, 2016

Abstract

I provide evidence that financial contagion risk is an important source of the equity risk premium. Banks' contributions to aggregate financial contagion are estimated in a state space framework and linked to systemic risk. Greater bank connectedness today leads to increased systemic risk 3-12 months later. More contagious banks earn significantly greater risk-adjusted returns than less contagious ones and the tradable high contagion-minus-low contagion bank portfolio is priced in the cross-section of stock returns. Stocks that co-move more strongly with contagious banks have greater expected returns. These results are robust to factor model specification, test assets, and time period considered.

Keywords: Asset pricing, Equity risk premium, Financial contagion, State-space modeling, Systemic risk

JEL Classification: C58, G12, G14, G21

Suggested Citation

Piccotti, Louis R., Financial Contagion Risk and the Stochastic Discount Factor (November 15, 2016). Piccotti, Louis R. (2017). Financial contagion risk and the stochastic discount factor, Journal of Banking & Finance 77, 230-248., Available at SSRN: https://ssrn.com/abstract=2411788 or http://dx.doi.org/10.2139/ssrn.2411788

Louis R. Piccotti (Contact Author)

Oklahoma State University - Stillwater - Spears School of Business ( email )

460 Business
Stillwater, OK 74078-0555
United States

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