This paper presents a test diagnostic that determines whether financial shocks are due to the propagation of idiosyncratic shocks originating in a single source country (or group of countries), or a reflection of market interdependence due to factors common across markets. The test is given by the ratio, λ, of the unconditional to the conditional correlation coefficient between markets. We demonstrate analytically that the test statistic is robust to heteroscedasticity due to conditional market volatility, to the impact of omitted variables (particularly important in the event that shocks may be transmitted between any two markets via a third ‘intermediate’ market) and to the impact of endogeneity between markets. Size and power characteristics of the test are strong. An application to the Asian financial crisis of 1997–1998, the subprime crisis of 2007 and the European crisis of 2009 demonstrates its empirical tractability. For the Asian and the subprime crises, the λ-test suggests that propagation of shocks was predominantly due to common fundamentals: in the European crisis shock propagation by contrast is indicated to be due to idiosyncratic shocks centred on Cyprus, Greece and Latvia.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics