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

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  • International Monetary Fund

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. We first present a simple model on how heterogeneous changes in investors' risk aversion affect portfolio decisions and stock prices. Second, we empirically show 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, we construct a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. This index can improve predictions about which countries are likely to be affected by contagion from crisis centers.

Suggested Citation

  • International Monetary Fund, 2004. "When in Peril, Retrench: Testing the Portfolio Channel of Contagion," IMF Working Papers 2004/131, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2004/131
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    Cited by:

    1. Tamim Bayoumi & Giorgio Fazio & Manmohan Kumar & Ronald MacDonald, 2007. "Fatal attraction: Using distance to measure contagion in good times as well as bad," Review of Financial Economics, John Wiley & Sons, vol. 16(3), pages 259-273.
    2. Hamidreza Tabarraei, 2014. "Euro-Crisis and Spillover Effects on the Emerging Economies," PSE Working Papers halshs-00952153, HAL.
    3. repec:zbw:bofrdp:2006_015 is not listed on IDEAS
    4. Hamidreza Tabarraei, 2014. "Euro-Crisis and Spillover Effects on the Emerging Economies," Working Papers halshs-00952153, HAL.
    5. Pami Dua & Divya Tuteja, 2016. "Contagion in International Stock and Currency Markets During Recent Crisis Episodes," Working papers 258, Centre for Development Economics, Delhi School of Economics.
    6. Jokipii, Terhi & Lucey, Brian, 2007. "Contagion and interdependence: Measuring CEE banking sector co-movements," Economic Systems, Elsevier, vol. 31(1), pages 71-96, March.

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    Keywords

    WP; emerging market; mutual fund;
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