A Regime Switching Skew-Normal Model for Measuring Financial Crisis and Contagion

Abstract

A regime switching skew-normal model for …nancial crisis and contagion is proposed in which we develop a new class of multiple-channel crisis and contagion tests. Crisis channels are measured through changes in ‘own’moments of the mean, variance and skewness, while contagion is through changes in the correlation and co-skewness of the joint distribution of asset returns. In this framework: i) linear and non-linear dependence is allowed; ii) transmission channels are simultaneously examined; iii) crisis and contagion are distinguished and individually modeled; iv) the market that a crisis originates is endogenous; and v) the timing of a crisis is endogenous. In an empirical application, we apply the proposed model to equity markets during the Great Recession using Bayesian model comparison techniques to assess the multiple channels of crisis and contagion. The results generally show that crisis and contagion are pervasive across Europe and the US. The second moment channels of crisis and contagion are systematically more evident than the …rst and third moment channels.