Differing investor perspectives: Revisiting contagion under perspective correlations

• Published date: 01 May 2021
• Author: Anjali Karol
• Date: 01 May 2021
• DOI: http://doi.org/10.1002/pa.2167

ACADEMIC PAPER

Differing investor perspectives: Revisiting contagion under

perspective correlations

Anjali Karol

Institute for Financial Management and

Research (IFMR), Chennai, India

Correspondence

Anjali Karol, Institute for Financial

Management and Research (IFMR), No:196,

TTK Road, Parthasarathy Garden, Alwarpet,

Chennai-600018, Tamil Nadu, India.

Email: anjali.k@ifmr.ac.in

This paper introduces a new correlation measure called perspective correlation

measure as a complement to the existing objective correlation measure to detect

contagion. Incorporating the effects of currency returns on correlation estimates,

we first demonstrate theoretically that the correlation experienced by two inves-

tors given a country pair can be different. This is because the correlation measures

are inherently distinctive, determined purely from the point of view of the investor,

the foreign exchange returns between the two countries for the investment period

and the currency in which the investor counts his or her returns. The same has

been evidenced from an empirical examination of weekly closing stock index

returns data from January 1996 to December 2017 for India and its three devel-

oped counterparts, namely, the US, the UK and Japan. Our results indicate that

India does not offer diversification benefits to developed country investors but the

converse is true.

1|INTRODUCTION

The colossal impact of 2007–09 Global Financial Crisis (GFC) on

both the United States and the world markets necessitated to relook

the understanding of contagion. Contagion is the spread of market

shock from one region, economy or market to other regions, econo-

mies or markets. As an impending risk of international financial inte-

gration, contagion can lead to excess volatility impairing the

economy and financial networks of other countries. This phenome-

non of contagion can be explicated from the perspective of the four

agents that influence financial globalization, namely, governments,

financial institutions, investors and borrowers (Schmukler, 2004).

This paper addresses international stock market contagion in the

aftermath of the GFC from the perspective of individual investors.

We introduce a simple framework for testing contagion that can

provide insights on the diversification benefits as experienced by

different investors.

The literature on contagion is multifarious in terms of its defini-

tion, scope, causes, consequences, channels of propagation, the ways

of measurement and its very predictability. Some researchers consider

trade and/or financial linkages and common shocks as the reason for

the spread of crises across countries. Forbes and Rigobon (2002) call

these strong linkages or a high degree of comovement across markets

during stable periods as interdependence. This interdependence can

lead to even stronger comovements when a crisis hits one of the

countries and thereby lead to contagion even without the occurrence

of any structural changes. Forbes and Rigobon (2001) define another

narrow term called shift contagion when a crisis management and

contingency mechanism set into action with some concomitant under-

lying structural changes. They came up with a working definition of

contagion by restricting contagion to only constitute significant

increases in cross-market linkages following a crisis. Contagion also

spreads as news about a crisis in some countries puts markets else-

where into a state of panic. This can be quantified as the rise in the

probability of a crisis at home due to a crisis elsewhere (Eichengreen,

Rose, & Wyplosz, 1996).

One approach to find evidence for contagion is to define conta-

gion as excess comovement of debt or equity returns across countries

during crisis periods (Bekaert & Harvey, 2003). Changes in correlation

coefficients of asset prices after controlling for fundamentals is an

indication of contagion (Forbes & Rigobon, 2001). An improvement

upon this method uses conditional correlation or conditional probabili-

ties (Kaminsky & Reinhart, 2000) to test whether the probability of a

country encountering a crisis rises when there is a crisis elsewhere in

the world. An altogether different approach investigates the role of

macroeconomic similarities among countries in influencing investor

Received: 17 June 2019 Revised: 26 March 2020 Accepted: 25 April 2020

DOI: 10.1002/pa.2167

J Public Affairs. 2021;21:e2167. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons, Ltd 1of8

https://doi.org/10.1002/pa.2167