Application of dynamic factor modelling to financial contagion

Contagion has been described as the spread of idiosyncratic shocks from one mar

ket to another in times of ?nancial turmoil. In this work, contagion has been

modelled using a global factor to capture the general market movements and

idiosyncratic shocks are used to capture co-movements and volatility spill-over

between markets. Many previous studies have used pre-speci?ed turmoil and

calm periods to understand when contagion occurs. We introduce time-varying

parameters which model the volatility spillover from one country to another. This

approach avoids the need to pre-specify particular types of periods using external

information. E?cient Bayesian inference can be made using the Kalman ?lter in

a forward ?ltering and backward sampling algorithm. The model is applied to

market indices for Greece and Spain to understand the e?ect of contagion dur

ing the European sovereign debt crisis 2007-2013 (Euro crisis) and examine the

volatility spillover between Greece and Spain. Similarly, the volatility spillover

from Hong Kong to Singapore during the Asian ?nancial crisis 1997-1998 has also

been studied.

After a review of the research work in the ?nancial contagion area and of the

de?nitions used, we have speci?ed a model based on the work by Dungey et al.

(2005) and include a world factor. Time varying parameters are introduced and

Bayesian inference and MCMC simulations are used to estimate the parameters.

This is followed by work using the Normal Mixture model based on the paper by

Kim et al. (1998) where we realised that the volatility parameters results depended

ii

on the value of the ‘mixture o?set’ parameter. We propose method to overcome

the problem of setting the parameter value.

In the ?nal chapter, a stochastic volatility model with with heavy tails for the

innovations in the volatility spillover is used and results from simulated cases and

the market data for the Asian ?nancial crisis and Euro crisis are summarised.

Brie?y, the Asian ?nancial crisis periods are identi?ed clearly and agree with

results in other published work. For the Euro crisis, the periods of volatility

spillover (or ?nancial contagion) are identi?ed too, but for smaller periods of

time.

We conclude with a summary and outline of further work.