Joshua Tan Co

ECOMET2 Final Reflection Paper

12/7/17

SUMMARY
In this paper, I review the work of Dungey, Fry, Gonzlez-Hermosillo, and Martin on
Empirical Modeling of Contagion: A Review of Methodologies (2004). The paper reviews the
alternative methods used to test for the presence of a contagion effect during periods of financial
crisis. In other words, if the covariance of asset returns in countries share the same amounts of
volatility. The authors look at the basic relationships between asset return during non-crisis and
crisis environments, as well as relationship between the model and the correlation tests for
contagion. In addition, they talk about multivariate testing, endogeneity issues, and structural
breaks.

To create a model of contagion, a model of interdependence must first be created among

countries. First a latent factor model is performed on the asset returns during non-crisis period.
This model is based on the asset pricing theory whereby the asset returns are based on a set of
factors taking both firm specific and market risk into account. All means are assumed to have zero
means. Particularly useful in any financial economic variable.

The equation stated has a variable for common shocks as well as a loading term, as well as
an idiosyncratic or a firm specific risk. These common shocks are just financial markets factors,
which represents market fundamentals that determine the average level of asset returns across
international markets during normal times. This world factor is assumed to be a latent stochastic
process with zero mean and unit variance. The properties of this factor captures richer dynamics
such as autocorrelation and time-varying volatility. Looking at the idiosyncratic or firm specific
risk, if the value is greater than 0, these firm specific risks cause the volatility in the asset returns.
This also has zero mean and unit variance. Now contagion , according to the authors, refers to the
transmission of unanticipated local shocks to another country or market, which consists of
common or specific spillovers that result from some identifiable channel, local or contagion.

The first model by Dungey, Fry, Gonzlez-Hermosillo and Martin (2002) defined
contagion as the effects of unanticipated shocks across asset markets during a period of crisis. One
equation contains a contagious transmission channel as represented by unanticipated local shocks
to the asset returns of a country. The fundamental aim of all empirical models of contagion is to
test the statistical significance of this parameter. Now, Bivariate testing refers to changes in the
volatility of pairs of asset returns, that is the change in the covariance between two periods. If the
parameter is positive, there is an increase in the covariance of asset returns during the crisis period
across countries. Whereas if the parameter is negative, there is a reduction in the covariance. In
both situations, there is contagion. Multivariate testing is possible, given that there are sufficient
moment conditions to identify the unknown parameters. A joint test is then run to determine if the
unconstrained model is just identified, or not. It is important, however, to separate the effects
between contagion and structural break. The authors do this by restricting the number of
contagious linkages. To make the equation more dynamic, 4 methods are possible. The first is lags
in the asset returns, or rather spillover effects, the second is lags in the market risk, the third is lags
in the firm-specific risk, and the fourth is the specification of dynamics in the variance. The fourth
is done by including a GARCH (generalized autoregressive conditional heteroscedastic) structure
on the factors.

The second model is by Forbes and Rigobon (2002). They defined contagion as the increase
in correlation between two variables during a crisis period. The correlation is volatility-adjusted
to increase the accuracy of the measurement. That is, separating volatility from actual contagious
effects between countries. This is done by using an unconditional correlation scaled by a nonlinear function of the percentage change in volatility in the asset return of the source country.
Another way of implementing this is to scale the asset returns and perform the contagion test within
a regression framework. That is, using OLS and testing the significance of the parameters. This
test is equivalent to a Chow test for a structural break of the regression slope. A multivariate testing
can be constructed as well. This is done by using a set of slope dummy variables to capture the
impact of contagion on asset returns. Subsequently, standard multivariate test statistics can be run
such as the likelihood ratio, Wald and Lagrange multiplier tests. The author notes that Rigobon
(2003) has an alternative multivariate test of contagion. This test is referred to as the determinant

of the change in the covariance matrix (DCC). It compares the covariance matrices across two
samples and then takes the determinant to express the statistic as a scalar. Where DCC=0, there is
no contagion effect, and where DCC>0, contagion increases volatility during the crisis period.
This can also be seen as an alternative to the chows test. According to the paper, under the DCC
test, the covariance matrices employed tend to be conditional covariance matrices if dynamics
arising from lagged variables and other exogenous variables are controlled for. When we use the
Forbes and Rigobon test, we must take into account potential simultaneity biases arising from the
presence of endogenous variables. It is important to note that the simultaneity bias is unlikely to
be severe if the size of the correlations between asset returns are relatively small. To correct for
simultaneity bias, the tests of contagion must be performed on simultaneous equations estimators.
Alternatively, the identification problem can be solved by including lagged variables. This way
there will be more parameters to identify the unknowns. And yet another method is through the
use of instrumental variables to obtain consistent parameter estimates.

The last model the authors mention is the use of asymmetrical adjustments. The reason for
this being that the contagion effect is nonlinearly different when compared to normal times. Four
models explain this. Favero and Giavazzi (2002) use a structural VAR to explain the unexpected
shocks across countries. We consider the shocks as the contagion effect. The residual values from
the SVAR are identified with a set of dummies indicating crisis observations. If these dummies
are significant, there is a contagion effect. A separate dummy variable is defined for each outlier
with the contagion test corresponding to a joint test that all parameters associated with the dummy
variables are zero. These dummies are taken as many (short-lived) crisis periods associated with
extreme returns.

Eichengreen, Rose, and Wyplosz (1995, 1996) and Kaminsky and Reinhart (2000)
modeled the contagion effect in currency markets across exchange rate regimes. They constructed
an Exchange Market Pressure Index (EMP) that is used to form a binary CRISIS index that
indicates whether or not a particular currency is experiencing extreme pressure. In this model,
dummy variables are made for all variables, both independent and dependent. This method focuses
on the change in the strength of the correlation during crisis periods. The EMP index also uses a
threshold value between crisis and non-crisis periods to measure this change in strength. In

constructing the binary dummies, linear regression can be performed to reduce the amount of lost
data.

Bae, Karolyi, and Stulz (2003) looked at the tails of the distribution of asset returns by
identifying the exceedances of individual returns and co-exceedances across asset returns. Similar
to the EMP, the tails uses a threshold to test for the exceedances. In addition, a multinomial logit
model can be used to analyze the exceedances, that is based on the probability that the coexceedances occur at time

Butler and Joaquin (2002) tested for contagion by looking at the direction of the crisis.
During positive shocks or bull markets, the difference in the correlations is broadly consistent with
a model drawn from a normal distribution. During negative shocks or bear markets, the rise in
correlation between asset returns far exceeds that associated with a normal distribution. This study
uses dummy variables as well to indicate bad news or good news.

REFLECTION
The paper by Dungey, et al. (2004), extensively presented just one of the many uses of time
series econometrics. A single topic of testing for contagion, and the models that can be used are
numerous. Single factors are changed. By looking at the different information that the variables or
the regression generates, one can run comparable tests. By introducing new parameters or looking
at the data in a different perspective, numerous analytical conclusions can be reached. I believe
that this shows the extent of data as well as the vast opportunities that it presents us with. Statistics,
or econometrics to be more exact, is so diverse and expansive. This just showed us but a glimpse
of its capabilities. The thing, however, with time series data and analysis is that it may seem to not
make any sense. The data may just move together without any econometric meaning. Therefore,
it is imperative that we have reason and intuition when looking at data. Much like what this paper
shows us, you can look at different facets of the regression and make correlations, but if you do
not have the intuition to back it up, it becomes simply that, co-movement. This is why economic
theory is so important. This coupled with a strong understanding of how the numbers work would
yield a multitude of benefits.

Going into the paper itself, I find it really interesting. I have always had a keen interest in
financial models, and I know that econometrics is a power tool in the field of finance. I find
econometrics a very difficult subject, and would really not mind if it were split into more than 2
different subjects. This is because it is so expansive and the possibilities are limitless. I am taking
Portiva now so I can really piece together the importance of what I am learning in time series with
the creation of portfolio investments. While ecomet2 provides me the tools for forecasting, portiva
gives me the theory. That is, it gives meaning to the models. These two courses seem to go hand
in hand.

With that said, I find this paper incredibly relevant especially in our current times. With
the increasing levels of globalization, it seems imperative that governments understand just how
related we are. With the world almost fully recovered from the 2008 financial crisis, it is clear that
we are not ready for another hit. By proving through empirical studies like this that there is indeed
a contagion effect, government policy can be focused on non-detrimental effects to reduce this.
Maybe by more regulations or more crisis procedures, countries will be able to defend themselves
against a total financial collapse. In addition to this, the studies can go even further and determine
the signs that point to a financial crisis to prevent a financial epidemic is such contagion effect
exists.

As we can see, the scope of econometrics is endless. We, as the next set of leaders in the
world will truly benefit from this understanding of numbers and data. By looking at the bigger
picture and opening our minds, we will be able to solve the cause not the symptom, and come up
with real, feasible and sustainable solutions to the problems today.