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

Author/Editor: Broner, Fernando | Gelos, Gaston | Reinhart, Carmen
Authorized for Distribution: July 1, 2004
Electronic Access: Free Full Text (PDF file size is 382KB)
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Summary: 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.
 
Series: Working Paper No. 04/131
Subject(s): Financial crisis | Emerging markets | Stock markets | Forecasting models
Author's keyword(s): Contagion | risk aversion | emerging markets | portforlio choice | financial crises
 
English  
    Published:   July 1, 2004        
    ISBN/ISSN:   1934-7073   Format:   Paper
    Stock No:   WPIEA1312004   Pages:   34
    Price:   US$15.00
       
     
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