Financial crisis and a transmission mechanism of external shocks: The signaling role of the Korean Monetary Stabilization Bond

Abstract

This paper explores a transmission mechanism of an exogenous shock to domestic financial markets by investigating the potential signaling role of the Monetary Stabilization Bond (MSB) spread together with several financial variables in Korea. The MSB spread widened and became more volatile during the crisis period after the variance change point at the end of 2007, when the causality relationships between the key variables became apparent. The empirical results illustrate that a foreign shock, which directly leads to rapid short-term capital flow and foreign exchange rate fluctuation, is likely to have a significant contagion effect on domestic financial markets in the case where it has a sizable negative impact on national foreign reserve holdings. The MSB is a monetary policy instrument for foreign exchange reserve management, and the daily observable MSB spread is a timelier signal in this transmission channel.