Aurora Borealis
1 April 2015 CFA Institute Journal Review

The Global Crisis and Equity Market Contagion (Digest Summary)

  1. Sandra Krueger, CFA

Policymakers and risk managers need to understand the causes of financial contagion. The authors examine evidence of contagion from US to global equity markets during the 2007–09 global financial crisis. Their results support the validity of a wake-up-call effect, where a financial crisis in one region is a wake-up call to investors in another and leads to the reassessment of fundamental vulnerabilities worldwide. Additionally, domestic banking policies seem to be a major source of domestic contagion.

What’s Inside?

The authors study the transmission of the 2007–09 financial shocks to stocks in over 50 developed and emerging markets. A three-factor model is used to benchmark global equity market co-movements. Contagion is defined as the co-movement in excess of that implied by this interdependence model. The authors find significant evidence of contagion during the 2007–09 time period.

Four types of contagion are analyzed by applying the interdependence model. US contagion occurs when shocks are transmitted from the United States to other markets, whereas global contagion measures how shocks travel from the global financial sector to other sectors through increasing degrees of co-movement. Domestic contagion measures an increasing co-movement of stocks within a single economy, whereas residual contagion is all co-movement not measured by the first three definitions of contagion.

The authors use their framework to examine channels of contagion resulting from the international banking sector, domestic financial policies, global trade, financial links, information asymmetries, the wake-up-call theory, and herding behavior. Surprisingly, trade links and globalization are not key drivers of contagion. The 2008 global financial crisis was driven primarily by domestic factors, whereas the 1998 Long-Term Capital Management and 2000 technology crises did not show evidence of domestic contagion.

How Is This Research Useful to Practitioners?

International policymakers are promising reforms to financial regulation, including an emphasis on identifying vulnerabilities and risk in the global financial system. How such risks are identified must be determined, in part, based on which channels of contagion are most important. For example, if direct financial channels are considered most important, a priority should be accorded to identifying domestic and cross-border financial exposures. Conversely, if the crisis seems to have occurred indiscriminately, driven by a herd mentality, prevention might place a greater weight on leverage and liquidity positions, risk management, and market infrastructure.

Even though the crisis began in the US financial sector, the authors find weak evidence of contagion from the US markets to global equity markets. Instead, they find stronger contagion from domestic equity markets to individual domestic equity portfolios.

They suggest that countries with large current account deficits, high political risk, high unemployment, and large government budget deficits encounter a high degree of contagion both from the United States and from domestic markets. This outcome supports the wake-up-call theory as a transmission device of the crisis. That is, once a financial vulnerability leads to a crisis in one country, other countries with similarly vulnerable economies are also likely to enter a crisis period as investors reassess the riskiness of these fundamentally vulnerable markets.

Not all countries implemented debt and deposit guarantees to help shield domestic markets from the impact of the crisis, but the authors find that bank policy measures did help protect countries and individual firms within the countries by reducing the magnitude of the contagion.

How Did the Authors Conduct This Research?

The authors seek to understand the transmission channels of the crisis across 55 countries and 10 sectors. They select firms that are frequently traded, have firm-specific data available, and are part of the main equity market index in each country. Approximately 2,000 firms are analyzed for which the authors have daily equity returns in US dollars. From firm-level data, they construct 415 country-sector portfolios.

The country-sector portfolios are value-weighted to relative market capitalization. The starting point of their analysis is 7 August 2007, when central banks first began intervention, and the last observation is 15 March 2009. Using their data to compute world market returns, the authors link the crisis with an equity market decline of about 50% from peak to trough. Regression models are used to partition increases in co-movement across the four areas of contagion.

Abstractor’s Viewpoint

The authors perform a comprehensive review of financial research on contagion, shock transmission, and international market integration. They expand on current research by adding a rigorous analysis of the sources of contagion.

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