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

35 Pages Posted: 15 Feb 2006

See all articles by Fernando Broner

Fernando Broner

CREI; Barcelona GSE; Universitat Pompeu Fabra; CEPR

Gaston Gelos

International Monetary Fund

Multiple version iconThere are 3 versions of this paper

Date Written: July 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. 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.

Keywords: Contagion, risk aversion, emerging markets, portfolio choice, financial crises

JEL Classification: F30, G15

Suggested Citation

Broner, Fernando and Gelos, R. Gaston, When in Peril, Retrench: Testing the Portfolio Channel of Contagion (July 2004). IMF Working Paper No. 04/131, Available at SSRN: https://ssrn.com/abstract=878956

Fernando Broner (Contact Author)

CREI ( email )

Ramon Trias Fargas, 25-27
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Spain
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HOME PAGE: http://www.crei.cat/people/broner

Barcelona GSE

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
+34 93 542 2601 (Phone)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain
+34 93 542 2601 (Phone)

HOME PAGE: http://www.crei.cat/people/broner

CEPR ( email )

London
United Kingdom
+34 93 542 2601 (Phone)

R. Gaston Gelos

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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