Diagnosing the Source of Financial Market Shocks: An Application to the Asian, Subprime and European Financial Crises

Research output: Contribution to journalArticle

Abstract

This paper presents a test diagnostic that determines whether financial shocks are due to the propagation of idiosyncratic shocks originating in a single source country (or group of countries), or a reflection of market interdependence due to factors common across markets. The test is given by the ratio, λ, of the unconditional to the conditional correlation coefficient between markets. We demonstrate analytically that the test statistic is robust to heteroscedasticity due to conditional market volatility, to the impact of omitted variables (particularly important in the event that shocks may be transmitted between any two markets via a third ‘intermediate’ market) and to the impact of endogeneity between markets. Size and power characteristics of the test are strong. An application to the Asian financial crisis of 1997–1998, the subprime crisis of 2007 and the European crisis of 2009 demonstrates its empirical tractability. For the Asian and the subprime crises, the λ-test suggests that propagation of shocks was predominantly due to common fundamentals: in the European crisis shock propagation by contrast is indicated to be due to idiosyncratic shocks centred on Cyprus, Greece and Latvia.

Original languageEnglish (US)
Pages (from-to)742-777
Number of pages36
JournalPacific Economic Review
Volume23
Issue number5
DOIs
StatePublished - Dec 1 2018

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Financial markets
Financial crisis
Asia
Subprime
Propagation
Idiosyncratic shocks
Subprime crisis
Greece
Omitted variables
Correlation coefficient
Conditional correlation
Endogeneity
Interdependence
Financial shocks
Cyprus
Diagnostic tests
Market volatility
Common factors
Asian financial crisis
Test statistic

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

Cite this

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abstract = "This paper presents a test diagnostic that determines whether financial shocks are due to the propagation of idiosyncratic shocks originating in a single source country (or group of countries), or a reflection of market interdependence due to factors common across markets. The test is given by the ratio, λ, of the unconditional to the conditional correlation coefficient between markets. We demonstrate analytically that the test statistic is robust to heteroscedasticity due to conditional market volatility, to the impact of omitted variables (particularly important in the event that shocks may be transmitted between any two markets via a third ‘intermediate’ market) and to the impact of endogeneity between markets. Size and power characteristics of the test are strong. An application to the Asian financial crisis of 1997–1998, the subprime crisis of 2007 and the European crisis of 2009 demonstrates its empirical tractability. For the Asian and the subprime crises, the λ-test suggests that propagation of shocks was predominantly due to common fundamentals: in the European crisis shock propagation by contrast is indicated to be due to idiosyncratic shocks centred on Cyprus, Greece and Latvia.",
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Diagnosing the Source of Financial Market Shocks : An Application to the Asian, Subprime and European Financial Crises. / Fedderke, Johannes Wolfgang; Marinkov, Marina.

In: Pacific Economic Review, Vol. 23, No. 5, 01.12.2018, p. 742-777.

Research output: Contribution to journalArticle

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