When in Peril, Retrench: Testing the Portfolio Channel of Contagion
IMF Working Paper No. 04/131
35 Pages Posted: 17 Sep 2004
Date Written: August 2004
One plausible mechanism through which financial market shocks may propagate across countries is through the effect of past gains and losses on investors' risk aversion. The paper first presents a simple model examining how heterogeneous changes in investors' risk aversion affects portfolio decisions and stock prices. Second, the paper shows empirically that, when funds' returns are below average, they adjust their holdings toward the average (or benchmark) portfolio. In other words, they tend to sell the assets of countries in which they were overweight, increasing their exposure to countries in which they were underweight. Based on this insight, the paper discusses a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.
Keywords: Contagion, international investors, risk aversion, emerging markets, portfolio choice, financial crises
JEL Classification: F30, G15
Suggested Citation: Suggested Citation