Modelling Financial Contagion: A Theoretical Analysis

By
Dinu Mathew Panampunna
PGPDCM II
(2004-06)

Submitted to
Mudra Institute of Communications, Ahmedabad
In partial fulfillment of the requirements for the Postgraduate Programme
Diploma in Communications Management

Dissertation Guide:
Dr. Rasananda Panda
Faculty, MICA

Mudra Institute of Communications, Ahmedabad

Ahmedabad
March 2006

Notice of Copyright

Mudra Institute of Communications

Copyright Dinu Mathew Panampunna 2006 and Mudra

Institute of Communications, Ahmedabad (MICA)

Executive Summary

The study attempts to sketch financial contagion as essentially a parametric

technique capable of being disseminated through mathematical equations.
Contagion is defined purely in terms of its empirical validity and the models
proposed henceforth are dependent on that definition. The literature on the
subject though not in any terms exhaustive has been examined for its robustness
and accessibility of rigour. The macro and micro economic factors of financial
distress has been touched upon with adequate explanations being provided
mathematically by different scenario testing. These have helped in attempting to
trace the evolution of the world factor to represent a variable that often goes
unobserved. Some testing models like bivariate and multivariate testing models
have been introduced to explain the factor model. The study attempts to sketch
the mathematical ideation behind time series analysis extending it into stochastic
processes. Therein an attempt has been made to model trends in financial data
by using Random Walk Hypothesis and its myriad variants. An S- Variant point
process model has been laid down to explain the effects that time and the type of
event has on the stock price. The stochastic intensity approach and its diagnostic
tool, the generalized Hawkes model has been introduced to further strengthen
the process. Itos Lemma has been introduced at this stage to test out the
deterministic and random component of a stock price and to analyse whether
one could explain any deterministic character out of the random component in
the Generalized Hawkes Model. Finally the study tries to look into the real world
and takes through a path of empirical studies on contagion throughout the
world. The study is highly quantitative and to facilitate easy understanding, a
brief synopsis is given at the beginning of each chapter.

ACKNOWLEDGEMENT

I am happy to place on record my gratitude towards numerous persons who have made
valuable contributions academically and non-academically towards the completion of this
work.
It is difficult for me to express in words the deep sense of gratitude I owe to Dr.
Rasananda Panda for his generous assistance, constant supervision, and patient forbearance to
the numerous problems and difficulties encountered during the present study. It would have
been impossible for me to do this study but for the inspiration I received from Prof. Panda at
different stages of my work.
I am thankful to Prof. Mathew, whom I constantly troubled with mallu expletives, Prof.
Neeraj Amarnani, Prof. Naval Bhargav, Dr. Shubhra Gaur, and Prof Anita Basalingappa for
their valuable suggestions as my dissertation Committee. I place my sincere gratitude for them
for spending their valuable time for discussion and help rendered to me for shaping the thesis.
I express my sincere thanks to my best friend Gujju, Shubs, Smita, Mohit and also Abhijit
who sat as a patient audience in my intellectual outbursts and for the encouragement they
have extended during my study. I also sincerely express my heart felt gratitude to my junior
Gaurav Bose who helped me in the type setting and also donned the role of a competitive
evaluator.
I would fail in my duty if I forget to place my heartfelt gratitude to my fiance, Lija
Ramachandran whose constant criticism and encouragement has helped me to improve the
work significantly.
Last but not least, I would fail in my duty if I forget to mention my heartfelt thanks to
my parents who have been my continuous source of inspiration and encouragement over the
years. Without their blessing, I would not have been able to start on and complete my
dissertation.
Dinu Mathew Panampunna

CONTENTS
Page No.
Notice of Copy right
Executive Summary
Acknowledgement
Chapter 1

Modelling Financial Contagion

1.1. Introduction
1.2. Review of Literature
1.3. Objective of the Study
1.4. Methodology
1.4 (a) Generalized Theoretical Models
1.4 (b) Empirical framework for intensity ana lysis
1.5. Contagion and Financial Crisis
1.6. Unanticipated Shock Models of Contagion
1.7. Bivariate Testing
1.8. Multivariate Testing
1.8 (a) Using Just Crisis Data
1.9. Databases
1.10 Scope of the Study
1.11 Limitations of the Study

Chapter 2

Theoretical Modelling of Contagion: A New

Perspective
2.1. A Mathematical Exposition into Time Series
Analysis
2.2. Stochastic Process
2.3. Non-Stationary Time Series and Random Walk
Hypothesis
2.4. Modeling Different Trends
2.5. S-variate point process
2.6. Stochastic Intensity Approach
2.7. Generalised Hawkes Model
2.8. The Theoretically Conceived Model
2.9. Ito's Lemma
2.10. Looking Ahead: Analysis of the Model and
Randomness

Chapter 3

Financial Contagion: Models and Perspectives

3.1. Financial Contagion: An Introspective Analysis
3.2. Market Interdependence and Crisis Thresholds
3.3. Conclusions and Findings
Reference
Appendix
Glossary
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25

Extreme, synchronized rises and falls in financial markets occur infrequently but
they do occur. The problem with the models is that they did not assign a high
enough chance of occurrence to the scenario in which many things go wrong at
the same time- the perfect storm scenario
(Business Week, September 1998).

That which is static and repetitive is boring. That which is dynamic and random
is confusing. In between lies art." John A. Locke

Regulators have criticized LTCM and banks for not stress-testing risk models
against extreme market movements... The markets have been through the financial
equivalent of several Hurricane Andrews hitting Florida all at once. Is the
appropriate response to accept that it was mere bad luck to run into such a rare
event - or to get new forecasting models that assume more storms in the future?
(The Economist, October 1998, after the LTCM rescue)

Chapter 1

Modelling Financial Contagion

Abstract

This chapter attempts to sketch financial contagion as essentially a

parametric technique capable of being disseminated through mathematical
equations. Contagion is defined purely in terms of its empirical validity and the
models proposed henceforth are dependent on that definition. The literature on
the subject though not in any terms exhaustive has been examined for its
robustness and accessibility of rigour. The macro and micro economic factors of
financial distress has been touched upon with adequate explanations being
provided mathematically by different scenario testing. These have helped in
attempting to trace the evolution of the world factor to represent a variable
that often goes unobserved. Some testing models like bivariate and multivariate
testing models have been introduced to explain the factor model.

1.1 Introduction

Financial risk-taking is a concern of public policy because associated with the risk
taking actions of individuals there are externalities, i.e. costs and benefits accruing
to the society that are external to the calculations of the individual investor, and
not accounted for in the market place. 1 1 In an economy where there are important
externalities, competitive markets will be socially inefficient. The task of public
policy, in this case of financial regulation, is to attempt to mitigate these
inefficiencies. Financial externalities are particularly potent because they are
transmitted macro economically. Yet despite all this talk of externalities, contagion
and panics, a peculiarity of market expectations is that they seem to be remarkably
stable (or tranquil) for substantial periods of time, even when underlying real
circumstances might be decidedly unpropitious.

Periods of tranquility defined by stable expectations and stable market confidence

may sustain the illusion that financial markets are truly reflecting a strong real
economy. The shattering of that illusion can be catastrophic.

1.2 Review of Literature

The externality of systemic risk is in large part manifest through what the
economist John Maynard Keynes called a beauty contest. In Keyness contest,
beauty is not in the eye of the beholder. Instead, the game is won by those who can
accurately assess what others think is beautiful. In financial markets, it is knowing
what others believe to be true that is the key to knowing how markets will behave.
The market is driven by participants belief about what average opinion believes
average opinion believes and so on, ad infinitum (Keynes 1936:; Eatwell and
Taylor 2000).
1

There are a number of other important market failures in the financial sector which attract the
concerns of public policy, most notably the asymmetry of information between individual savers
and market professionals that is the motivation of consumer protection. This lecture deals solely
with the market failure manifest in systemic risk.

Individual investors and traders must be highly heterogeneous, with different

financial objectives. In traditional economics this was described as the difference
between those seeking income certainty and those seeking wealth certainty, with
different patterns of risk aversion, different investment time horizons and so on
(Robinson 1951).

Liberalisation of financial markets that has taken place over the past 3 decades has
inevitably reduced the heterogeneity in financial markets. By definition
liberalisation has broken down market segmentation - cross- market correlations
have risen sharply. And with liberalisation has come a growing professionalisation
of financial management (BIS 1998: chpt. V), and extensive consolidation of
financial institutions (Group of Ten 2001). The professional investor is not only
subject to a continual pressure to maximize shortterm returns, but also in a
competitive market myopic (i.e. short-time horizon) investment is an optimal
strategy (Kurz 1987). So whatever the preferences of the private investor might be,
convergence on myopic strategies by professional investors is homogenizing the
market.

Macroeconomic and microeconomic aspects of international regulation

Public policy also needs to take into account the fact that beliefs about average
opinion transmit externalities through macroeconomic variables the interest rate
say, or the general level of stock prices, or the exchange rate. So effective
regulation of firms should be conceived in conjunction with macroeconomic
policy. This is particularly true in an international setting, where a major focus of
systemic risk is the exchange rate. In policy terms, macroeconomic action may be
a far more efficient means of reducing systemic risk than traditional
microeconomic regulation.

1.3 Objective of the Study

My main objective through this study would be to analyse the following,

1) To theoretically conceive a new perspective to capture multivariate

market event data based on real time econometric methods

1.4 Methodology
The methodological aspects of the study would focus on the following

1.4(a) Generalized Theoretical Models

To analyse the above stated objective the following methodology is proposed. The
study will briefly describe the aspects of PP theory that are central to the paper and
discuss an intensity based approach to inference for PPs. I adopt a different
approach in which the model is specified via the vector stochastic intensity. This
provides a natural and powerful modeling framework for multivariate market
event data. Each element of the stochastic intensity is a continuous time process
that may be interpreted as the conditional hazard for the particular type of market
event in question. The field upon which the hazard is conditioned is updated
continuously as new information arrives, thus allowing other types of event to
influence the hazard as they occur in continuous time. My approach is closest to
that of Russell (1999), who also specfies a multivariate PP model via the stochastic
intensity.

Therein I would like to introduce a new class of models for financial market event
data (the generalized Hawkes) models. These allow the estimation of the nature of
the dependence of the intensity on the events of previous trading days rather than
imposing strong, a priori assumptions concerning this dependence. Continuing
from the generalized Hawkes model I would attempt to build on the suggestions of
Russell (1999) for the construction of diagnostic tests for parametric, multivariate
PP models.

10

1.4(b) Empirical framework for intensity analysis

Using the theoretical framework, an empirical framework shall be developed to

estimate the nature and magnitude of the intensity of variables occurring as
conditional hazards on the financial market

1.5 Contagion and Financial Crisis

There is now a reasonably large body of empirical work testing for the existence of
contagion during financial crises. A range of different methodologies are in use,
making it difficult to assess the evidence for and against contagion, and
particularly its significance in transmitting crises between countries. 2 The origins
of current empirical studies of contagion stem from Sharpe (1964) and Grubel and
Fadner (1971), and more recently from King and Wadhwani (1990), Engle, Ito and
Lin (1990) and Bekaert and Hodrick (1992).

Before developing a model of contagion, a model of interdependence of asset

markets during non-crisis periods is specified as a latent factor model of asset
returns. The model has its origins in the factor models in finance based on
Arbitrage Pricing Theory for example, where asset returns are determined by a set
of common factors and a set of idiosyncratic factors representing non-diversifiable
risk (Sharpe 1964; Solnik 1974). Similar latent factor models of contagion are used
by Dungey and Martin (2001), Dungey, Fry, Gonzalez Hermosillo and Martin
(2002a), Forbes and Rigobon (2002) and Bekaert, Harvey and Ng (2003).

The literature on financial crises themselves is much wider than that canvassed here and is
reviewed in Flood and Marion (1998) while more recent papers are represented by Allen and
Gale (2000), Calvo and Mendoza (2000), Kyle and Xiong (2001) and Kodres and Pritsker
(2002).

11

To simplify the analysis, the number of assets considered is three. Extending the
model to N assets is straightforward with an example given below. Let the returns
of three asset markets during a non-crisis period be defined as

{x1 ,t, x2,t, x3,t } . (1.1)

All returns are assumed to have zero means. The returns could be on currencies, or
national equity markets, or a combination of currency and equity returns in a
particular country or across countries. The following trivariate factor model is
assumed to summarise the dynamics of the three processes during a period of
tranquility.

xi,t = i wt + i ui,t , i= 1, 2, 3..(1.2)

The variable wt represents common shocks that impact upon all asset returns with
loadings i. These shocks could represent financial shocks arising from changes to
the risk aversion of international investors, or changes in world endowments
(Mahieu and Schotman 1994; Rigobon 2003b). In general, wt represents market
fundamentals which determine the average level of asset returns across
international markets during normal, that is, tranquil, times. This variable is
commonly referred to as a world factor, which may or may not be observed. Much
would be talked about this factor model in the next chapter.

1.6 Unanticipated Shock Models of Contagion

The definition of the term contagion varies widely across the literature. In this
paper contagion is represented by the transmission of unanticipated local shocks to
another country or market. This definition is consistent with that of Masson
(1999a,b, c), who divides shocks to asset markets as either common, spillovers that
result from some identifiable channel, local or contagion, and as shown below that
of other approaches, such as Forbes and Rigobon (2002) where contagion is

12

represented by an increase in correlation during periods of crisis. The first model

discussed is based on the factor structure developed by Dungey, Fry, GonzalezHermosillo and Martin (2002a,b) amongst others, where contagion is defined as
the effects of unanticipated shocks across asset markets during a period of crisis.
To distinguish between asset returns in a non-crisis and crisis period, yi,t represents
the return during the crisis period and xi,t the return during the non-crisis period.
Consider the case of contagion from country 1 to country 2. The factor model is
now augmented as follows

y1,t = 1 wt + 1 u1,t
y2,t= 2 wt + 2 u2,t + u1,t

...................(1.3)

y3,t = 3 wt + 3 u3,t
where the xi,t are replaced by yi,t to signify demeaned asset returns during the
crisis period. The expression for y2,t now contains a contagious transmission
channel as represented by unanticipated local shocks from the asset market in
country 1, with its impact measured by the parameter . The fundamental aim of
all empirical models of contagion is to test the statistical significance of the
parameter . 3

1.7 Bivariate Testing

Bivariate tests of contagion focus on changes in the volatility of pairs of asset

returns. From (1.3), the covariance between the asset returns of countries 1 and 2
during the crisis is

An important assumption underlying 3 is that the common shock and idiosyncratic shocks have
the same impact during the crisis period as they have during the non-crisis period.

13

E [y1,t ,y2,t] = 1 2 + 1 .(1.4)

Comparing this expression with the covariance for the pre-crisis period in (2)
shows that the change in covariance between the two periods is

E [y1 ,t,y2,t] . E [x1,t x2,t] = 1 .(1.5)

If > 0, there is an increase in the covariance of asset returns during the crisis
period as 1 > 0 by assumption. This is usually the situatio n observed in the data.
However, it is possible for < 0, in which case there is a reduction in the
covariance. Both situations are valid as both represent evidence of contagion via
the impact of unanticipated shocks in (1.3).

1.8 Multivariate Testing

The test for contagion presented so far is a test for contagion from country 1 to
country 2. However, it is possible to test for contagion in many directions provided
that there are sufficient moment conditions to identify the unknown parameters.
For example, (1.3) can be extended as

y1,t = 1 wt + 1 u1,t + 1,2 u2,t + 1,3 u3,t

y2,t = 2 wt + 2 u2,t + 2,1 u1,t + 2,3u3,t

.(1.6)

y3,t = 3 wt + 3 u3,t + 3,1 u1,t + 3 ,2 u2,t,

In this case there are 6 parameters, i,j , controlling the strength of contagion across
all asset markets. This model, by itself, is unidentified as there are 12 unknown
parameters. However, by combining the empirical moments of the variancecovariance matrix during the crisis period, 6 moments, from the empirical

14

moments from the variance-covariance matrix of the pre-crisis period, another 6

moments, gives 12 empirical moments in total which can be used to identify the 12
unknown parameters.

1.8 (a) Using Just Crisis Data

Identification of the unknown parameters in the factor model framework discussed

above is based on using information from both non-crisis and crisis periods.
However, there may be a problem for certain asset markets in using non-crisis data
to obtain empirical mo ments to identify unknown parameters, such as for example
in the move from fixed to floating exchange rate regimes during the East Asian
currency crisis. However, it is possible to identify the model using just crisis
period data, provided that the number of asset returns exceeds 3 and a limited
number of contagious links are entertained. For example, for N = 4 asset returns,
there are 10 unique empirical moments from the variance-covariance matrix using
crisis data. Specifying the factor model in for N = 4 assets, means that there are 4
world parameters and 4 idiosyncratic parameters. This suggests that 2 contagious
links can be specified and identified.

1.9 Databases

The study will be based on secondary data. It will be a purely theoretical

exposition into financial risk management. Empirical testing of the subsequent
models on the two principal stock exchanges should be the next phase of study,
though its beyond the scope at this juncture. Major sources of data would be from
the period bulletins from the two principal stock exchanges of the country. In
addition to these, annual reports from SEBI, RBI etc would be used as
supplementary tools for analysis.

1.10 Scope of the Study

15

Randomness has always been a critical aspect of study in financial markets.

Financial mathematics is a field that is currently in full growth. Financial
mathematics presents a source of interesting mathematical problems from the
modeling of financial phenomena to the development of high performance tools
that implement such models. Areas of research involving complex mathematical
models are gaining huge significance after the pricing of options successfully in
the Black-Scholes equation.

1.11 Limitations of the Study

Randomness as a theoretical concept has been relatively easy to interpret and

model. Extension analysis to the empirical phenomenon would be beyond the
scope of the present realm of study. This would also require a greater deal of
mathematical expertise involving complex time series analysis both discrete and
continuous. This can be considered to be a sever limitation imposed on the study
which restricts the empirical validity of the theoretical construct that is being
proposed.

The next chapter goes on to explain in detail the modeling of the hazards that
accompany a contagion and trying to make use of robust models to predict the
hazard variables.

Chapter 2

Theoretical Modeling of Contagion: A New Perspective

Abstract

16

This chapter attempts to sketch the mathematical ideation behind time series
analysis extending it into stochastic processes. Therein an attempt has been
made to model trends in financial data by using Random Walk Hypothesis and
its myriad variants. An S- Variant point process model has been laid down to
explain the effects that time and the type of event has on the stock price. The
stochastic intensity approach and its diagnostic tool, the generalized Hawkes
model has been introduced to further strengthen the process. Itos Lemma has
been introduced at this stage to test out the deterministic and random
component of a stock price and to analyse whether one could explain any
deterministic character out of the random component in the Generalized
Hawkes Model.

2.1 A Mathematical Exposition into Time Series Analysis

17

There are two main goals of time series analysis: (a) identifying the nature of the
phenomenon represented by the sequence of observations, and (b) forecasting
(predicting future values of the time series variable). Both of these goals require
that the pattern of observed time series data is identified and more or less formally
described. Once the pattern is established, one can interpret and integrate it with
other data. Mathematical ideation behind Time Series Analysis (TSA) is the
concept of an abstract probability space defined as (, F, P) such that 0<Ti Ti+1
Where, Sample space
F Sigma Algebra defined in
P Probability on
Ti point process on (0,

2.2 Stochastic Process

In the mathematics of probability, a stochastic process is a random function. In the
most common applications, the domain over which the function is defined is a
time interval (a stochastic process of this kind is called a time series in
applications) or a region of space (a stochastic process being called a random
field). Mathematically it can be defined as a family of random variables {x (t,w),
t T, w defined on a probability space (, F, P)}

2.3 Non-Stationary Time Series and Random Walk Hypothesis

If a time series is stationary, its mean, variance, and autocovariance (at various
lags) remain the same no matter at what point one measures the m; that is they are
time invariant. Such a time series will tend to return to its mean and fluctuations
around this mean (measured by its variance) will have a broadly constant
amplitude. If a time series is not stationary in the sense just defined, it is called a

18

non-stationary time series. In other words, a non-stationary time series will have a
time- varying mean or a time- varying variance or both.

Its very important to understand why a stationary time series is important over a
non-stationary one. If a time series is non-stationary, one can study its behaviour
only for the time period under consideration. Each set of time series data will be
therefore for a particular episode. As a reason it is not possible to generalize it to
other time periods. Therefore for the purpose of forecasting, such nonstationary
time series may be of little practical value.

Classical example of a nonstationary time series is the random walk model

(RWM). It is often said that asset prices, such as stock prices or exchange rates,
follow a random walk which is nonstationary. There are two types of the RWM,
namely the random walk without the drift (no constant or intercept term) and the
random walk with drift.

2.4 Modeling Different Trends

Economic data usually follow trends. One typically distinguishes deterministic and
stochastic trends. Consider the following model of time series Yt
Yt = 1 + 2 .t + 3 Yt-1 + ut

.(2.1)

ut white noise error term and t is measured chronologically.

A stochastic process that is purely random is referred to as white noise.
All this throws open different possibilities,

a) Pure Random Walk

If 1

0; 2 =0; 3 =1; one gets

19

Yt = Yt-1 + ut
which is nothing but a pure random walk without drift and hence is non-stationary
Yt = (Yt Yt-1 ) = ut

---- (2.2)

which then becomes a difference stationary process

If

1 =0; 2 =0; 3 =1;

Yt = 1 + Yt-1 + ut
Yt = 1 +ut

----- (2.3)

Here Yt exhibits a stochastic trend (positive or negative) depending on the value of

i. RWM with or without drift would be non-stationary and could be converted
into a stationary series by taking the first difference.

b) Deterministic Trend
If 1

0; 2

0; 3 =0

Yt = 1 + 2 .t + ut

Trend Stationary Process ---

(2.4)
Here though the mean of Yt is 1 + 2 .t, its variance is. Once the means of 1 and 2
are known, the mean can be forecast perfectly. Therefore if one subtracts the mean
of Yt from Yt , the resulting series will be stationary, hence the name trend
stationary.

c) Random walk with drift and deterministic trend

If 1

0; 2

0; 3 =1

Yt = 1 + 2 .t + Yt-1 + ut

---------------(2.5)

Here Yt is non-stationary

20

It becomes pertinent at this point after laying out all the possibilities of the RWM
and having determined its variability of its trends to look into more specific factors
and theoretical constructs that define and determine multivariant market event
data. (Multivariate refers to more than one event under consideration). A relevant
issue to be considered at this point is whether the obvious difficulties of modeling

Multivariate market event data could not be mitigated somewhat by adopting a

simpler approach based on time series methods, rather than attempting to set the
models in continuous time. I believe that the development of statistical models for
market event data set in continuous, real time to be an important challenge in
financial econometrics for the following reasons. First, models set in event time
may well ignore aspects of the evolution of the market that are economically
important. In addition, most practical applications of models of market event data
such as volatility measurement and the design of optimal order submission
strategies require that the models relate somehow to real time.

A standard time series analysis of aggregated data using fixed intervals of real time
is also problematic. Since the data records the timing and characteristics of
individual market events, aggregation involves an undesirable loss of information.
Thus the characteristics and timing relations of individual transactions will be lost,
mitigating the advantages of moving to transactions data in the first place. The
considerations set out above suggest that models for market event data set in
continuous time are likely to provide important economic insights into the
functioning of financial markets.

2.5 S-variate point process

Let {Ti}i

(1,2.)

be a simple point process on [0, ] defined on (, F, P) and

{Zi}i (1,2...) be a sequence of {1,2.. M} valued random variables. Then the

double sequence

21

{Ti, Zi}i

{1,2}

is called a S-variate point process on [0, ]. Econometrically

speaking, market event data can be viewed as the realisation of a Marked Point
Process that is, as the realisation of a double sequence(Ti;Zi)i (1;2;:::) of random
variables where Ti is the random occurrence time of the ith event and Zi is a vector
of additional variables (or `marks') associated with that event.
where Ti Occurrence time of the ith market event
Zi The event type
Whilst considerable progress has been made in modeling the univariate case using
time series models of durations, multivariate extensions of this work have been
slow to emerge in the econometrics literature. It is believed that approaching the
problem of modelling multivariate market event data by directly specifying the
stochastic intensity provides a powerful, flexible framework.

There is a family of models, the generalised Hawkes models for which analytic
likelihoods are available and diagnostic tests based on the integrated intensity can
be constructed. In contrast to previous work, the models are general enough to
allow one to estimate the nature of the dependence of the intensity on the events of
previous trading days rather imposing strong apriori assumptions concerning this
dependence.

This approach recognises a significant feature of financial markets: namely, that

for the majority of markets, the market does not operate continuously so that the
question of dependence between trading days is of considerable importance.
Furthermore, the models have intuitively appealing economic interpretations since
the stochastic intensity for events of a particular type can be interpreted as a
conditional hazard that is, as the conditional expectation in the limit of the number
of events of that type that will occur per unit time in the future given the current
(multivariate) information set.

22

Now with a plethora of activities affecting a single event it would be difficult to

analyse the impact of conditional hazards unless one goes in for a segregation
analysis. There should again be an intensity filter which would filter out the
contagion hazards. In contrast to previous work, the models (Here we are talking
of the Generalised Hawkes Model) are general enough to allow us to estimate the
nature of the dependence of the intensity on the events of previous trading days
rather imposing strong apriori assumptions concerning this dependence. This
approach recognises a significant feature of financial markets: namely, that for the
majority of markets, the market does not operate continuously so that the question
of dependence between trading days is of considerable importance.

2.6 Stochastic Intensity Approach

After determining the trend modeling process one should be able to proceed with
the earlier specification of the model via stochastic intensity.

Let N(t) be a simple point process on (0,) defined on (0, , P) that is adopted to
some filtration {F t } and let Pt be a positive, Ft predictable process.

E [N(t) N(s)/F s] = E [ s

(n) dn/F s]

.......................(2.6)

This is one of the most crucial assumptions that we could be making. The
conditional expectation of the point process N(t) after filtering out the effects
through stochastic intensity should very well be the standing ground on the basis
of which the whole theoretical construction can be accepted or rejected. The
stochastic filter should be able to identify conditional hazards after having
observed the historical pre determined predicted contingency effects. The
extensional analysis should go from here to a very explicit assumption of trying to

23

predict the additional events from hereon. This would form the very crux of what
the study started out to achieve.

The simple assumption could be as follows;

Standing at time s having observed the history Fs and if one wishes to predict the
numbers of additional events that will occur by time t using the conditional
expectation of (N t Ns)/Fs. Then one can equivalently use
E [s t (u) du/Fs]

(2.7)

For all s, t such that 0 s t,

(t) is the intensity of N(t)

(2.8)

One has to carefully look back at this point for introspection since this forms one
of the crucial building blocks for the analysis. This is also one of the inflexion
points where the study lacks the depth for overall understanding of the subject.
The intensity factor culled out based on the predicted Ft process could very well
have been empirically tested for its validity based on the past data and the financial
scams that have rocked the Indian financial market.

At the theoretical level, tracing the observed herding behavior to market

participants uncertain beliefs and information asymmetries is a key element for
understanding how contagious effects arise. It is argued that the recent focus on
better understanding of high- frequency financial returns data and decision making
at the market microstructure level are promising avenues for understanding the
transmission of shocks across markets and countries.

2.7 Generalised Hawkes Model

24

The model is defined by the stochastic intensity

(t) = (t) + j=1

j(t)

(2.9)

(t) is a positive, deterministic function of time and for j = 1,2.. k

j=1

j(t) represents k non-deterministic components

Stochastic intensity of the Hawkes model is thus the sum of the deterministic
compone nt output t and k non-deterministic components (j(t)jk = 1)
The mathematical rigor needed for the complete explanation of the Hawkes model
is beyond the scope of the present study but at this juncture it gives us that much
needed theoretical support to continue to go along with the original idea of
separating the conditional hazards. It seems very much an empirical impossibility
to mathematically model these hazards but the purpose of the study has to be
looked upon the light of it providing a new perspective to the idea of modeling
financial contagion. To simplify the issue further strong assumptions needed to be
made at this point. The Hawkes model might well end up by assuming that the non
deterministic component as defined by the Hawkes model follows a martingale
process.

In probability theory a discrete time martingale is a discrete time stochastic

process X1, X2, X3, that satisfies the identity
(2.10)

i.e; the conditional expected value of the next observation, given all the past
observations, is equal to the last observation.

2.8 The Theoretically Conceived Model

It may seem too far fetched at this point of time to introduce a theoretically
conceived model but for all its uncertainties. The construction may well be a
25

hazard in itself but the entire intellectual process should be viewed in the light of
creating an entirely new perspective to the randomness approach. Financial
markets and contingencies have always aroused the curiosity of the academia at
large though randomness still remains a topic to be studied at large.

The randomness of the non deterministic component still lurks in the dark and in
this situation another strong conceptual assumption is being made. The non
deterministic component as derived in the Hawkes Model may well follow Itos
Lemma (Proof derived in the appendix).

2.9 Ito's Lemma

Changes in a variable such as stock price involve a deterministic component which
is a function of time and a stochastic component which depends upon a random
variable. Let S be the stock price at time t and let dS be the infinitesimal change in
S over the infinitesimal interval of time dt. The change in the random variable z
over this interval of time is dz. The change in stock price is given by

dS = adt + bdz.
(2.11)

dS- Change in stock price

dt- infinitesimal change in time
dz- infinitesimal change in randomness in time dt

where a and b may be functions of S and t as well as other variables.

The expected value of dz is zero so the expected value of dS is equal to the
deterministic component, adt.

The random variable dz represents an accumulation of random influences over the

interval dt. The Central Limit Theorem then implies that dz has a normal

26

distribution and hence is completely characterized by its mean and standard

deviation. The mean or expected value of dz is zero. The variance of a random
variable which is the accumulation of independent effects over an interval of time
is proportional to the length of the interval, in this case dt. The standard deviation
of dz is thus proportional to the square root of dt, (dt)1/2 . All of this means that the
random variable dz is equivalent to a random variable w(dt)1/2 , where w is a
standard normal variable with mean zero and standard deviation equal to unity.

One of the strongest assumptions in this study is being put forward. It can be put
forward that the non-deterministic component is a function of the change in stock
price and time. If a change in stock price is ultimately related to as explained in
(2.11) and if one makes the assumption that the random component is a function of
the stock price and time, it should naturally follow that this random component
should have a deterministic and a non-deterministic component.

Consider the following mathematical assumptions,

As mentioned earlier,

dS = adt + bdz,

Now suppose that j(t)jk = 1, the random component as derived in the Hawkes
model is a function of stock price and time.
j(t)jk

S,

T)(2.12)
Because j(t)jk is a function of the stochastic variable S, it will have a stochastic
component as well as a deterministic component.
representation of the form:
dj(t)jk = pdt +
qdz(2.13)

27

j(t)jk

will have a

The crucial problem is how the functions p and q are related to the functions a and
b in the equation
dS = adt + bdz.

Ito's Lemma gives the answer. The deterministic and stochastic components are
given by:
p= f/ t+( f/ S)a +(1/2)( 2f/ S2 ) b2 (2.14)
q = ( f/ S)b.(2.15)

2.9 Looking Ahead: Analysis of the Model and Randomness

Humankind has been concerned with randomness since prehistoric times, mostly
through divination (reading messages in random patterns) and gambling. The
opposition between free will and determinism has been a divisive issue in
philosophy and theology . Mathematicians focused at first on statistical
randomness and considered block frequencies (that is, not only the frequencies of
occurrences of individual elements, but also those of blocks of arbitrary length) as
the measure of randomness, an approach that extended into the use of information
entropy in information theory.

Some argue randomness should not be confused with practical unpredictability,

which is a related idea in ordinary usage. Some mathematical systems, for
example, could be seen as random; however they are actually unpredictable. This
is due to sensitive dependence on initial conditions (see chaos theory). Many
random phenomena may exhibit organized features at some levels. For example,
while the average rate of increase in the human population is quite predictable, in
the short term, the actual timing of individual births and deaths cannot be
predicted. This small-scale randomness is found in almost all real- world systems

28

Sensibly dealing with randomness is a hard problem in modern science,

mathematics, psychology and philosophy. Merely defining it adequately, for the
purposes of one discipline has proven quite difficult. Distinguishing between
apparent randomness and actual randomness has been no easier. In addition,
assuring

unpredictability,

especially

against

well- motivated party (in

cryptographic parlance, the "adversary"), has been harder still.

Some philosophers have argued that there is no randomness in the universe, only
unpredictability. Others find the distinction meaningless.

All these lend credence to the model explained in the study. The theoretical
construction followed has shed some illuminating insights into the deterministic
randomness of the non-deterministic component. Once the values of the constant
are known it makes sense then to model out the deterministic nature of the
randomness associated with forecasting randomness. Randomness as a concept
looks beyond the inevitable and this study has been an attempt to model the
invisible within the explicit.

This theoretical construct may seem incredulous but it certainly sheds light into a
new perspective of looking at randomness. Though its empirical validity requires
complex spread sheet programs and voluminous data the theoretical underpinnings
gives us no reason to absurdity. Complex algorithms could be made based on these
models, though at the present time, the lack of it, severely acts as an impediment to
its credibility and subsequent validity.

29

Chapter 3
Financial Contagion: Models and Perspectives

3.1 Financial Contagion: An Introspective Analysis

Use of the word contagion to describe the international transmission of financial
crises has become fraught with controversy, to the extent that some recent authors
have seen fit to avoid using the word entirely; see Favero and Giavazzi (2002) and
Rigobon (2003). The term evokes an emotive response among both producers and
consumers of research on international financial markets, and there is no general
agreement over its use.

Emotional responses stem in part from the borrowing of epidemiological

terminology contagion is intrinsically associated with disease, and even more
dismally with death, as contagion was often used as a synonym for the Bubonic
Plague in Europe as late as the 19th century. The term also implies, at least to
some, that those who fall prey to financial crises do so through no fault of their
own. However, this is an idea that some analysts are inclined to strongly resist:
speculators appear to discriminate in choosing the countries they attack.

A variation on the above definition is whether contagion represents the

unanticipated transmission of shocks. When cross-country linkages countries are
anticipated for instance through trade and financial flows or other a priori links then these represent fundamental linkages, hence they are not contagion. Arguably,
the particular channel through which contagion is transmitted is equally important,
such as through financial markets, trade relations, political linkages and
expectations. Researchers emphasizing the importance of identifying the channels
argue that this is a way of reassuring observers that underlying the estimated
correlations is really the international transmission of financial stress, and not

30

simply variables which are common across countries but omitted from the
specification.

The choice of fundamentals is not independent of the problem at hand. The

literature tends to adopt definitions of contagion specific to each application, and
given the difficulties inherent in defining the appropriate control variables this may
be appropriate. As a result, contagion may in fact be a concept that is defined
relative to a particular set of fundamentals, so its appropriate definition is the comovement of excess returns in one country with excess returns in another country
after controlling for the effects of specified fundamentals. Contagion is then
defined relative to the chosen fundamentals control group.

If financial contagion is associated with excess returns, then the problem of

defining these is immediately raised. To know when returns are excessive
requires an effective model of asset prices during normal times. At a minimum, the
statistical properties of financial markets data need to be accommodated in any
modeling exercise 4 .distributions of daily financial market returns are typically
non-normal

and

display

volatility

clustering

(time-varying

heteroscedasticity/GARCH effects) and fat tails (leptokurtosis). Thus, researchers

proposing to model financial market processes should arguably be expected to
reproduce these characteristics. The production of data distributions with fat tails
requires some form of non- linearity, and introducing this constitutes an important
strand of contagion research.

3.2 Market Interdependence and Crisis Thre sholds

One set of stylized facts for contagion is the existence of strong regional effects in equity and currency
market contagion, such as documented by Agenor, Miller, Vines and Weber (1999), Eichengreen
(2002), Kaminsky and Reinhart (2002) and Krugman (2000). However, for bond market data this
regionality does not seem to be present, a feature noted by Masson, Chakravarty and Gulden (2003)
and confirmed in Dungey, Fry, Gonzalez-Hermosillo and Martin (2002) in a study of the Russian and
LTCM crises.

31

In order to isolate contagious effects, the relative strength of market

interdependence and contagion need to be both modeled simultaneously and
separately identified. Interdependence, as opposed to contagion, occurs if crossmarket co-movement is not significantly bigger after a shock to one country, or
group of countries. Controlling for this is easier in a bivariate setting with two
countries and two asset markets than in a multivariate environment, although the
resulting dynamics are not as rich.

There has been extensive evidence of rising correlation between international

financial markets in recent decades, keeping pace with the trend towards capital
account liberalization; see, for example, Longin and Solnik (1995). More recently,
the bivaria te test for significant changes in the conditional correlation between
asset returns over noncrisis and crisis periods was popularised by Forbes and
Rigobon (2001, 2002). Applications include Baig and Goldfajn (1999) and Ellis
and Lewis (2000). This is the most common test in the literature; some of the
relevant issues in running it are covered in Corsetti, Pericoli and Sbracia (2001),
Loretan and English (2000) and Boyer, Gibson and Loretan (1999). The
correlation test is a variant of the World Banks very restrictive definition of
contagion, although in the majority of applications there is some attempt to control
for (a limited set of) fundamentals 5 .

Leading indicators of financial crises serve to avert policy makers to looming

crises. They also present one means of identifying thresholds between non-crisis
and crisis periods. Unfortunately, very few fundamental indicators are found to be
statistically significant control variables in existing applications.

Perhaps more disturbingly, crisis indicators based on fundamental indicators have

also proved to have poor predictive power in forecasting financial crises; see, for
example, Edison (2000) and Berg and Patillo (1999). This is reflected in the
5

Butler and Joaquin (2002) conduct tests consistent with the very restrictive definition of contagion,
although their paper is not directly addressing this issue.

32

heterogeneity of currency crises causes and features for different countries,

documented in Frankel and Rose(1996), as well as in the unpredictability of
reversals in short-term capital flows, emphasized by Calvos (1998) sudden stops.
Poor predictive power suggests that nonlinearity and breaks in the generating
processes of financial market data are pervasive, as discussed earlier.
Susceptibility to contagion is highly non- linear, and historical relationships
however robust are not useful in predicting future financial crises.

More generally, models of financial contagion can be classified as fundamental or

behavioural. In the first category the analysis is event-driven, where the event is
usually a financial crisis. Examples include the applications of Glick and Rose
(1999) and Van Rijikghem and Weder (2001) to shocks from a particular country
identified as country zero. On the other hand, behavioural models consider that
changing beliefs and herding underlie the transmission of shocks between countries.
A good example is the situation presented by Miller, Thampanishvong and Zhang
(2003) investigating the turmoil in Brazilian financial markets in 2001. Although
turmoil existed in Brazilian financial markets, the feared event of sovereign debt
default did not materialize. Consequently, there was no identifiable crisis event
rather, the turmoil was caused by fear of the potential cost of default. A useful
distinction between the biological and behavioural models is that biological models
tend to operate in a time series domain, following an event, whereas fundamental
models operate in both time series and cross-section dimensions.

Macro economic equilibria may also explain the contagion phenomenon.

Macroeconomic models with rational expectations generically have multiple
solutions. It follows that researchers different informational assumptions can have
different implications regarding the number of equilibria. If a given set of
fundamentals can give rise to multiple equilibria, then speculative attacks can be
self- fulfilling and contagion can also be irrational, that is unanticipated. Within a
cross-section, investors behavior can be interpreted as jumps between different
equilibria. The issue of multiplicity is critical for some models of contagion for
example, see Shillers (2000) account of the U.S. stock market bubble in the late
33

1990s. The strength of the self- fulfilling mechanism for contagion may also be a
potent explanatory factor underlying the collapse of the ERM in 1992-93; see
Drazen and Masson (1994).

3.3 Conclusions and Findings

Containing the likelihood of contagious financial crises is a pressing policy issue

at both national and international levels. As yet, there is no professional consensus
on the appropriate definitions of what constitutes a financial crisis or contagion,
despite substantial research progress towards these goals. We know that financial
crises and contagion are intrinsically linked, and that contagious effects arise when
crises are propagated across countries or markets after controlling for fundamental
linkages and interdependencies. We also know that these transmissions may spread
further through mechanisms such as cross- market hedging.

However, broad agreement can be obtained on the following points:

1. Crises are in some way associated with an increase in the conditional volatility
of financial market returns.

2. The association of excess returns in one country or market with excess returns
in another country after controlling for fundamentals (excess co- movement) is
consistent with financial market contagion.

3.

The theoretical model outlined in the second chapter provides a new

perspective of using stochastic intensity as a filter

4. The theoretical insights into Itos lemma and its application into volatility
models sheds light into randomness

34

5. The association of randomness in non-deterministic models may help in making forecasts smoother leading to better
accuracy.

New models will undoubtedly be required with the advent of new crises. However,
some of the salient aspects outlined in this study are likely to recur. These include:
the fundamental linkages, the means of transmission across countries and asset
classes, the statistical properties of the data, the simultaneous identification of
contagion, interdependency and herding and the endogenous identification of crisis
and non-crisis periods from sample data. Each of these issues is extremely
important for assessing the appropriate policy response to prevent crises and
adequately managing those that occur.

35

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39

Appendix
Derivation of Itos Lemma
The Taylor series for f(S,t) gives the increment in j(t)jk as:
dj(t)jk

= ( f/ t)dt + ( f/ S)dS +(1/2)( 2f/ S2)(dS)2 +( 2f/ S t)(dS)(dt) +

(1/2)( 2f/ t2)(dt)2 + higher order terms.

The increment in stock price dS is given by
dS = adt + bdz,
but dz=vw[dt]1/2 , where w is a standard normal random variable. Substitution of
adt + bvw(dt)1/2 for dS in the above equation yields:
dj(t)jk = ( f/ t)dt + ( f/ S)adt + f/ S)bvw(dt)1/2 + 1/2( 2 f/ S2 )(adt + bvw(dt)1/2 )2
+ ( 2 f/ S t)(adt + bvw(dt)1/2 )(dt) + 1/2( 2 f/ t2 )(dt)2 + higher order terms.
With the expansion of the squared term and the product term the result is:
dj(t)jk

f/ S)bvw(dt)1/2+ (1/2)( 2f/ S2)(a2dt2 +

= ( f/ t)dt + ( f/ S)adt +

2abvw(dt)3/2 + b2 v2w2dt)+ ( 2f/ S t)(a(dt)2 + bvw(dt)3/2) + 1/2( 2f/ t2)(dt)2+

higher

order

terms.

Taking into account the infinitesimal nature of dt so that dt to any power

higher than unity vanishes, reduces to:
dj(t)jk = ( f/ t)dt + ( f/ S)adt + ( f/ S)bvw(dt)1/2+ 1/2(

40

f/ S2)(b2v2w2dt)

Noting that the expected value of w2 is unity the expected value of dj(t)jk
is:
[ f/ t + ( f/ S)a + 1/2( 2 f/ S2 )b2 ]dt.
This is the deterministic component of dj(t)jk . The stochastic component is the
term that depends upon dz, which in (8) is represented as vw(dt)1/2. Therefore the
stochastic component is:

[( f/ S)b]dz(
1)

From the above derivation it would seem that there is an additional stochastic term
that arises from the random deviations of w2 from its expected value of 1; i.e., the
additional

term

(1/2)( 2 f/ S2 )(b2 v2 w2 dt)

(2)
However the variance of this additional term is proportional to (dt)2 whereas the
variance of the stochastic term given in (1) is proportional to (dt). Thus the
stochastic term given in (2) vanishes in comparison with the stochastic term given
in (1)

41

Glossary

Contagion This follows Eichengreen and Rose (1995) and Eichengreen, Rose
and Wyplosz (1996), who propose that contagion refers to the association of
excess returns in one country with excess returns in another country after
controlling for the effects of fundamentals. This definition is closely related to
true contagion, as defined in Kaminsky and Reinhart (2000), arising in the
absence of, or after controlling for, common shocks and all possible
interconnection channels.

Stochastic process- Any variable whose value changes over a period of time in an
uncertain way is said to follow a stochastic process. They can be classified into
discrete time and continuous time, where in the latter the underlying va riable can
take any value within a certain range while only certain discrete value are possible
in the former

Sigma field- -algebra, a mathematical concept, is a collection of subsets of a

given set. It is a key concept necessary for the definition of measure, which is itself
a key concept in analysis. Mathematicians who research and study probability
often refer to -algebras as -fields.

Systematic Risk- Risk that cannot be diversified and arises due to the correlations
between the returns from the investment and the stock market as a whole. The
investor expects a rate of return higher than the risk- free interest rate for bearing
positive amounts of systematic risk.

Non-systematic Risk- Non-systematic risk should not be at all important to an

investor. It can be almost completely elimintated by a well diversified portfolio

42

Itos Lemma This is derived from the Itos process. This is a generalised
stochastic process where the parameters a and b are functions of the value of the
underlying variable, x, and time, t. Both the expected drift and variance rate of an
Ito process are liable to change over time. This is used in the derivation of the
famous Black Scholes equation in the pricing of European options

Black-Scholes Pricing Formulae- In their path breaking paper, Black and Scholes
succeeded in solving their differential equation to obtain exact formulas for the
prices of European call and put options

Normal Distribution- A distribution with mean zero and standard deviation one

43