Global crises and equity market contagion

"As financial markets take another turn, this column explores lessons from the global crisis of 2007-2009 and discusses the source and determinants of contagion. It argues that real and financial linkages to the US or the global economy played a relatively minor role. Instead the crisis was a “wake-up call” to investors to pay more attention to countries’ policies and fundamentals.

The collapse of global equity markets between August 2007 and March 2009 has been part of the most severe global crisis since the Great Depression. While the crisis initially had its origin in the US in a relatively small market segment, the subprime mortgage market, it rapidly spread across virtually all economies, with many countries experiencing even sharper equity market crashes than the US. This makes this episode an ideal laboratory to revisit the debate about the presence and sources of contagion in global equity markets.

The definition of the term contagion remains highly controversial (see eg Forbes and Rigobon 2002). A relatively agnostic proposition derives from the asset pricing literature and defines contagion as co-movements of equity returns above and beyond what can be explained by fundamentals. Using this approach, we analyse the equity market transmission of the 2007-09 global financial crisis to sector portfolios in 50 countries through three channels: via US equity markets, via the global financial sector and via domestic equity markets (see Bekaert et al 2011). This approach thus identifies three different types of contagion, linked to each of these channels..."

at http://www.voxeu.org/index.php?q=node/6858