Lizarazo, Sandra (2009): Contagion of Financial Crises in Sovereign Debt Markets.
Download (347Kb) | Preview
This paper develops a quantitative model of contagion of financial crisis and sovereign default for small open economies that cannot credibly commit to honor their international debts and have common international risk averse investors. The existence of common investors with preferences that exhibit decreasing absolute risk aversion (DARA) generates financial links between the emerging economies sovereign debt markets that help to explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices as function not only of the economy's fundamentals, the investors' characteristics (wealth, and degree of risk aversion) but more importantly of the fundamentals of other emerging economies. Therefore this paper provides a theoretical formalization that is the base for and endogenous explanation of the contagion of financial crises. The model shows that whenever a country suffers a domestic shock that forces it to default in its debts, this domestic shock will affect the investor's wealth and therefore her tolerance of risk, producing a contagion of the crisis in those countries whose fundamentals are not solid enough. Also, even when the crisis in a country does not force such country to default, the domestic shock affects the overall riskiness of the investor's portfolio, forcing her to rebalance it. In this case the investor moves away from countries that are ``too'' risky towards countries that are relatively solid, exhibiting a behavior consistent with the observed phenomena denominated as ``flight to quality''. Quantitatively, the application of the model to the case of the Argentinean default of $2001$ and the posterior contagion of the crisis to the neighboring country Uruguay shows that the model with financial links is not only consistent with the business cycle behavior of emerging economies considered but it is also superior to models that do not contemplate such links in the following dimensions: i.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets; ii.) the model explains endogenously the positive correlation between the economies' sovereign bonds spreads, debt flows and consumptions, and iii.) the model exhibits the behavior observed in the data of higher volatility and comovement of the series of emerging economies during periods of volatility in financial markets prompted by the crisis in some emerging country.
|Item Type:||MPRA Paper|
|Original Title:||Contagion of Financial Crises in Sovereign Debt Markets|
|Keywords:||Contagion, Default, Sovereign Debt, Financial Crises, Sovereign bond spreads|
|Subjects:||F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F42 - International Policy Coordination and Transmission
F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
|Depositing User:||Sandra Lizarazo|
|Date Deposited:||04. Mar 2012 19:59|
|Last Modified:||20. Feb 2013 01:19|
Aiyagari, R., (1994). ''Uninsured Idiosyncratic Risk and Aggregate Saving''. Quarterly Journal Of Economics August 1994. 660-684
Aguiar, M., and Gopinath, G., (2006). Defaultable Debt, Interest Rates and the Current Account. Journal of International Economics 69, 64-83, 2006.
Arellano, C., (2008). Default Risk and Income Fluctuations in Emerging Economies. American Economic Review 98, 670-712, 2008.
Arellano, C., and Ramanarayanan, A., (2008). Default and Maturity Structure in Sovereign Bonds. Economic Research Papers} Federal Reserve Bank of Minneapolis, Staff Report 410 2008.
Bai, Y., and Zhang, J.,(2006). Financial Integration and International Risk Sharing. Working Paper Michigan University, 2006.
Baig, T., and Goldfajn, I.,(1998). ''Financial Market Contagion in the Asian Crisis''.IMF Working Paper WP/98/155, November 1998.
Baig, T., and Goldfajn, I.,(2000). ''The Russian default and the Contagion to Brazil''. IMF Working Paper WP/00/160, October 2000.
Cantor, R., and Packer, F, (1996). ''Determinants and Impact of Sovereign Credit Ratings''. Federal Reserve Bank of New York. Economic Policy Review October 1996.
Chatterjee, S., Corbae, D., Nakajima, M., and Rios-Rull, J., (2002). ''A Quantitative Theory of Unsecured Consumer Credit with Risk of Default''. Working Paper, March 2002
Choueri, N., (1999). ''A model of Contagious Currency Crises with Application to Argentina''. IMF Working Paper WP/99/29, March 1999.
Corsetti, G., Presenti, P., Roubini, N., and Tille, C., (1998). ''Competitive devaluations: a welfare based approach''.Working Paper December 1998.
Cuadra, G., and Sapriza, H., (2008). Sovereign default, interest rates and political uncertainty in emerging markets. Journal of International Economics , 2008 (forthcoming).
Cunningham, A., Dixon, L., and Hayes, S., (2001). ''Analyzing Yield Spreads on Emerging Market Sovereign Bonds''. Financial Stability Review}, December 2001.
De Gregorio, J., and Valdes, R., (2000). ''Crisis Transmission: Evidence from the Debt, Tequila, and Asia Flu Crises''.Working paper part of the WIDER/World Bank Research Project Contagion: How it Spreads and How it can be Stopped.
Diao, X., Li, W., and Yeldan, E., (2000). ''How the Asian Crisis Affected the World Economy: A General Equilibrium Perspective''. Federal Reserve Bank of Richmond. Economic\ Quarterly Volume 86/2 Spring 2000, 35-59.
Dornbusch, R., Park, Y., and Claessens, S., (2000). '' Contagion: How it spreads and How it can be stopped''. Working paper} May 2000
Durbin, E., and Ng, D., (1999). '' Uncovering Country Risk in Emerging Market Bond Prices''. Board of Governors of the Federal Reserve System. International Finance Discussion Papers Number 639, July 1999.
Eaton, J., and Gersovitz, M.,(1981). ''Debt with Potential Repudiation: Theoretical and Empirical Analysis''. Review of Economic Studies Vol XLVIII, 289-309.
Edwards, S., (2000). ''Interest Rates, contagion and Capital Controls''. NBER Working Paper \ 7801, July 2000
Edwards, S., and Susmel, R., (2000).''Interest Rate Volatility and Contagion in Emerging Markets: Evidence from the 1990s''. NBER Working Paper \ 7813, July 2000
Edwards, S., and Susmel, R., (2001).''Volatility Dependence and Contagion in Emerging Equity Markets''. NBER Working Paper} 8506, October 2001
Ferruci, G., Herzberg, V., Soussa, F., Taylor, A., (2004). Understanding Capital Flows to Emerging Market Economies. Financial Stability Review: June 2004.
FitzGerald, V., and Krolzig, D., (2003). Modeling the Demand for Emerging Market Assets.Working Paper, April (2003).
Forbes, K., (2001).'' Are trade linkages important determinants of country vulnerability''. NBER Working Paper\ 8194, March 2001
Forbes, K., (2000). '' Asia Flu and Russian Virus: Firm level evidence on how crisis are transmitted internationally''.NBER Working Paper 7807, July 2000
Forbes, K., and Rigobon, R., (2000). ''Contagion in Latin America Definitions Measurement and Policy implications''. NBER Working Paper 7885, September 2000
Frankel, J., and Schmukler, S., (2000). ''Country Funds and Asymmetric Information''. International Journal of Finance and Economics 5: 177-195 (2000)
Goldstein, I., and Pauzner, A., (2001). ''Contagion of self-fulfilling financial crises due to Diversification on Investment portfolios''.Working Paper June 2001
Hatchondo, J., Martinez, L. and Sapriza H., (2008) Heterogeneous Borrowers in Quantitative Models of Sovereign Default International Economic Review (forthcoming), (2008).
Hatchondo, J. and Martinez, L. (2009)Long-Duration Bonds and Sovereign Defaults. Journal of International Economics (forthcoming), (2009).
Hernandez, L., Mellado, P., and Valdes, R., (2001). ''Determinants of Private capital flows in the 1970s and 1990s: Is there evidence of Contagion?''.IMF Working Paper WP/01/64, May 2001.
Hernandez, L., and Valdes, R., (2001). ''What drives Contagion: Trade, Neighborhood, or Financial links''. IMF Working Paper WP/01/29, March 2001.
Kaminsky, G., and Reinhart, C., (2000).''The Center and the Periphery: Tales of Financial Turmoil''. Working Paper, January 2000.
Kaminsky, G., and Reinhart, C., (1998). ''Financial Crises in Asia and Latin America: Then and Now''. American Economic Review Vol 88, Issue 2, Papers and Proceedings of the Hundred and Tenth Annual Meeting of the American Economic Association, May 1998, 444-448.
Kamisnky, G., Lyons, R., and Schmukler, S., (2000). ''Economic Fragility Liquidity and Risk: the behavior of mutual funds during crises''. Working Paper, January 2000.
Kamisnky, G., Lyons, R., and Schmukler, S., (1999).''Managers Investors and Crisis Mutual Fund Strategies in Emerging Markets''. Working Paper, December 1999.
Kamisnky, G., Lyons, R., and Schmukler, S., (2001). ''Mutual Fund Investment In emerging Markets: An Overview''. The World Bank Economic Review}, Vol 15, No 2 315-340.
Kaminsky, G., and Schmukler, S., (1999).''What triggers Market Jitters?''. Working Paper, March 1999.
Kletzer, K. and Wright, B.,(2000). Sovereign Debt as Intertemporal Barter. American Economic Review 90(3), 621-639, 2000.
Kocherlakota, N., (2000). ''Creating Business Cycles Through Credit Constraints''. Federal Reserve Bank of Minneapolis. Quarterly Review Vol 24 No 3, Summer 2000, pp 2-10.
Kyle, A., and Xiong., W., (2001). '' Contagion as Wealth Effect''. Journal of Finance Vol LVI, No 4, August 2001.
Lagunoff, R., and Schreft, S., (2001).''A model of Financial Fragility''. Journal of Economic Theory 99, 220-264, (2001).
Lizarazo, S., (2010).''Default Risk and Risk Averse International Investors''. Working Paper, March 2005.
Masson, P., (1998). ''Contagion: Monsoonal Effects, Spillovers, and Jumps between Multiple Equilibria''. IMF Working Paper WP/98/142, September 1998.
Mendoza, E. and Yue, V., (2008). ''A Solution to the Default Risk-Business Cycle Disconnct''. FRB International Finance Discussion Paper 924, Mach 2008.
Merrick, J., (2000). ''Crisis Dynamics of Implied Default Recovery Ratios: Evidence from Russia and Argentina''. Working paper . Stern School of Business, New York University.
Paasche, B., (2001). ''Credit Constraints and International Financial Crises''. Working Paper January 2001
Presenti, P., and Tille, C., (2000). '' The Economics of Currency Crisis and Contagion: An Introduction''. Federal Reserve Bank of New York. Economic Policy Review September 2000.
Pritsker, M., (2000). ''The Channels for Financial Contagion''. Working Paper, August 2000.
Schinasi, G., and Smith, T., (1999).'' Portfolio Diversification, Leverage, and Financial Contagion''. IMF Working Paper WP/99/136, October 1999.
Valdes, R., (1996).''Emerging Markets Contagion: Evidence and theory''. Banco Central de Chile. Documentos de Trabajo del Banco Central.
Van Rijckeghem, C. and Weder, B., (1999). ''Sources of Contagion: Finance or Trade?''.IMF Working Paper WP/99/146, October 1999.
Yue, V., (2006). Sovereign Default and Debt Renegotiation. Working Paper, New York University, November 2006.
Available Versions of this Item
- Contagion of Financial Crises in Sovereign Debt Markets. (deposited 04. Mar 2012 19:59) [Currently Displayed]