DP3310 Some Contagion, Some Interdependence: More Pitfalls in Tests of Financial Contagion

Author(s): Giancarlo Corsetti , Marcello Pericoli , Massimo Sbracia

Publication Date: April 2002

Keyword(s): contagion , financial crisis , factor model , correlation analysis

JEL(s): C10 , F30 , G10 , G15

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3310.asp

This Paper develops a test of contagion in financial markets based on bivariate correlation analysis, which generalizes existing tests, and applies it to the international effects of the Hong Kong stock market crisis of October 1997. Contagion is defined as a structural break in the international transmission of financial shocks. For plausible values of the variance of country-specific shocks in Hong Kong, our test finds evidence of contagion for 5 countries out of a sample of 17. This is in sharp contrast with the findings of recent literature, according to which there is 'no contagion, only interdependence'. We show that this strong result in the literature is due to arbitrary and unrealistic restrictions on the variance of country-specific shocks.