Fatal Attraction: A New Measure of Contagion

IMF Working Papers, April 1, 2003

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Fatal Attraction: A New Measure of Contagion

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Bibliographic details

• Authors: Tamim Bayoumi, Manmohan S. Kumar, Giorgio Fazio, Ronald MacDonald
• Published: April 1, 2003
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451850321.001

Summary

• Proposes a new measure of contagion that is effective at anticipating future vulnerabilities.
• Builds on previous work by using correlations of equity markets across countries to measure contagion.
• Diverges from previous practice by measuring contagion through the relationship of these correlations with distance.
• Introduces a test that identifies periods of "positive contagion"—episodes in which capital flows to emerging markets in a herd-like manner, largely unrelated to fundamentals.
• Labels such periods "fatal attraction," noting they provide essential ingredients for subsequent crises and rapid outflows of capital.

Methodology

• Uses correlations of equity markets across countries as the basis for measuring contagion.
• Measures contagion via the relationship between these equity-market correlations and distance (departure from prior approaches that did not focus on distance).

Key Findings

• The proposed measure is good at anticipating future vulnerabilities.
• The test can identify periods of "positive contagion" when capital inflows to emerging markets display herd-like behavior not tied to fundamentals.
• Periods of "fatal attraction" create conditions that can lead to subsequent crises and rapid capital outflows.

Policy Implications and Relevance

• Identifying "fatal attraction" periods is important for early warning and crisis prevention because they signal heightened vulnerability to rapid reversals in capital flows.
• Monitoring equity-market correlation patterns across countries and their relationship with distance can improve surveillance of emerging and frontier financial markets.

Subject Areas and Keywords

• Subject: Balance of payments, Capital inflows, Emerging and frontier financial markets, Exchange rates, Financial markets, Foreign exchange, Real exchange rates, Stock markets
• Keywords: Asia and Pacific, Asia crisis, Capital inflows, Contagion, crisis, crisis outbreak, Emerging and frontier financial markets, emerging market crises, exchange rate panel, Exchange rates, international capital flows, market correlation, Real exchange rates, Russia crisis, Stock markets, tequila crisis, uninformed investor, WP

Content in this bundle

• Fatal Attraction: A New Measure of Contagion - WP/03/80
  • Fatal Attraction: A New Measure of Contagion - WP/03/80 (Markdown version)
  • Fatal Attraction: A New Measure of Contagion - WP/03/80 (PDF)