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When in peril, retrench: testing the portfolio channel of contagion
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When in peril, retrench: testing the portfolio channel of contagion

Author

Listed:
  • Fernando Broner
  • Gaston Gelos
  • Carmen M. Reinhart

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. The paper first presents a simple model examining how heterogeneous changes in investors? risk aversion affects portfolio decisions and stock prices. Second, the paper shows empirically 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, the paper discusses a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.

Suggested Citation

  • Fernando Broner & Gaston Gelos & Carmen M. Reinhart, 2004. "When in peril, retrench: testing the portfolio channel of contagion," Working Paper Series 2004-28, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2004-28
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    More about this item

    Keywords

    Risk; Investments;

    JEL classification:

    • F02 - International Economics - - General - - - International Economic Order and Integration
    • F30 - International Economics - - International Finance - - - General
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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