Forbes and Rigobon’s method of contagion analysis with endogenously defined crisis periods – an application to some of Eurozone’s stock markets

Abstract

The existent literature provides numerous definitions and statistical methods for analysis of contagion in the financial markets. The definition of shift contagion of Forbes and Rigobon (2001) and their adjusted correlation analysis (Forbes and Rigobon, 2002) have gained a lot of attention but the later faces the problem of ad hoc determination of the crisis periods and the issue of volatility adjustment. The aim of this paper is to elaborate the weaknesses of the method of Forbes and Rigobon and to provide a modification of their test that addresses these issues. To achieve this, a moving-window approach of Forbes and Rigobon’s (2002) method is proposed, by splitting the moving-windows into two equally sized sub-windows. We then apply the modified method to examine whether there was a (shift) contagion in the stock markets of five Eurozone countries (namely France, Germany, Ireland, Italy, and Spain) in the time period from December 2003 to January 2012. We found that shift contagion has played an important role in the propagation of shocks in the investigated stock markets during the crises. The start of the Greece’s debt crisis in May 2010 coincided with contagion from the Ireland’s, Italy’s, and Spain’s stock markets to the stock markets of France and Germany. Similar episodes of contagion were indentified around the Middle East financial crisis, at the end of 2006 and the start of 2007. The global financial crisis coincided with contagion from the Italy’s and Spain’s to the German stock market, while the Ireland’s debt crisis with contagion from the Ireland’s to the German stock market. The results of the paper have important implications for the investors in these stock markets. In the mainstream financial literature it has been recognized that international diversification reduces the total risk of a portfolio. This is due to non-perfect positive co-movement between returns of the portfolio assets. Increased co-movement between asset returns, identified during financial market turmoil, therefore can diminish the advantage of internationally diversified investment portfolios. The contagion analysis is also important for financial sector supervisory authorities and the monetary policy as different policy actions may be successful when the increase in co-movement between financial markets is a result of contagion or a result of a change in interdependence between the markets.

DOI: http://dx.doi.org/10.5755/j01.ee.24.4.5419