When in Peril, Retrench: Testing the Portfolio Channel of Contagion

IMF Working Paper No. 04/131

35 Pages Posted: 17 Sep 2004

See all articles by Fernando Broner

Fernando Broner

CREI; Barcelona GSE; Universitat Pompeu Fabra; CEPR

Gaston Gelos

International Monetary Fund

Carmen Reinhart

National Bureau of Economic Research (NBER); Peter G. Peterson Institute for International Economics; Harvard University - Center for Business and Government; Harvard University, Harvard Kennedy School (HKS), Belfer Center for Science and International Affairs (BCSIA) ; University of Maryland - School of Public Affairs; World Bank; Centre for Economic Policy Research (CEPR); International Monetary Fund (IMF); Harvard University - Harvard Kennedy School (HKS)

Multiple version iconThere are 3 versions of this paper

Date Written: August 2004

Abstract

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

Broner, Fernando and Gelos, R. Gaston and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen, When in Peril, Retrench: Testing the Portfolio Channel of Contagion (August 2004). IMF Working Paper No. 04/131, Available at SSRN: https://ssrn.com/abstract=591064 or http://dx.doi.org/10.2139/ssrn.591064

Fernando Broner (Contact Author)

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R. Gaston Gelos

International Monetary Fund ( email )

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Carmen Reinhart

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