Disequilibria and Contagion in Financial Markets: Evidence from a New Test

Abstract

This paper provides an analysis of contagion by measuring disequilibria in risk premium dynamics. We propose to test financial contagion using an econometric procedure where we first estimate the preference parameters of the consumption-based asset pricing model (C-CAPM) to measure the equilibrium risk premia in different countries and then we consider the difference between empirical and equilibrium risk premia to test cross-country disequilibrium episodes due to contagion. Disequilibrium in financial markets is modeled by the multivariate DCC-GARCH model including a deterministic crisis variable. Our approach allows to identify the disequilibria generated by increases in volatility that is not explained by fundamentals but is endogenous to financial markets and to evaluate the existence of contagion effects defined by exogenous shifts in cross-country return correlations during crisis periods. Our results show evidence of contagion from the U.S. to U.K., Japan, France, and Italy during the crisis started in 2007–08.