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

July 1, 2004

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When in Peril, Retrench: Testing the Portfolio Channel of Contagion, (USA: International Monetary Fund, 2004) accessed January 15, 2025

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.

Subject: Asset prices, Competition, Emerging and frontier financial markets, Mutual funds, Stock markets

Keywords: Emerging market, Mutual fund, WP

Publication Details

Pages:

34
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2004/131
Stock No:

WPIEA1312004
ISBN:

9781451855319
ISSN:

1018-5941

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