Correlation Analysis of Financial Contagion: What One Should Know Before Running a Test

38 Pages Posted: 27 Jun 2001

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

European University Institute; University of Cambridge; Centre for Economic Policy Research (CEPR)

Marcello Pericoli

Bank of Italy

Massimo Sbracia

Bank of Italy

Date Written: April 2001

Abstract

This paper builds a general test of contagion in financial markets based on bivariate correlation analysis - a test that can be interpreted as an extension of the normal correlation theorem. Contagion is defined as a structural break in the data generating process of rates of return. Using a factor model of returns as theoretical framework, we nest leading contributions in the literature as special cases of our test. We show that, while the literature on correlation analysis of contagion is successful in controlling for a potential bias induced by changes in the variance of global shocks, current tests are conditional on a specific yet arbitrary assumption about the variance of country specific shocks. Our results suggest that, for a number of pairs of country stock markets, the hypothesis of 'no contagion' can be rejected only if the variance of country specific shocks is set to levels that are not consistent with the evidence.

Keywords: Contagion, financial crisis, correlation analysis

JEL Classification: F30, C10, G10, G15

Suggested Citation

Corsetti, Giancarlo and Pericoli, Marcello and Sbracia, Massimo, Correlation Analysis of Financial Contagion: What One Should Know Before Running a Test (April 2001). Available at SSRN: https://ssrn.com/abstract=274894

Giancarlo Corsetti (Contact Author)

European University Institute ( email )

University of Cambridge ( email )

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Marcello Pericoli

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

HOME PAGE: http://www.bancaditalia.it

Massimo Sbracia

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy
+39 06 4792 3860 (Phone)
+39 06 4792 4118 (Fax)

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