Tail Risks, Asymmetric Contagion and Domino Patterns in Emerging Currency Markets

Abstract

We identify new structural channels for the transmission of shocks in emerging currencies, and develop a model in which shock propagations evolving from domestic emerging stock markets, liquidity (banks’ credit default swaps), credit risk (Volatility Index) and growth (commodity prices) channels disseminate to emerging market foreign exchanges. We quantify joint downside risks and document that these asset classes tend to experience concurrent extreme shocks. We measure the time-varying shock spillover intensities to ascertain a significant increase in cross-asset linkages during periods of high volatility which is over and above any expected economic fundamentals, providing strong evidence of asymmetric investor induced contagion, triggered by cross asset rebalancing. The critical role of the credit crisis is amplified, as the beginning of an important reassessment of emerging market currencies which lead to changes in the dependence structure, a revaluation and recalibration of their risk characteristics. By modelling tail risks we detect structural breaks and find patterns consistent with the domino effect. JEL Classification: C5, F31, F37, G01, G17.