Working Paper: CEPR ID: DP5117
Authors: Anna Pavlova; Roberto Rigobon
Abstract: This paper examines the co-movement among stock market prices and exchange rates within a three-country Centre-Periphery dynamic equilibrium model in which agents in the Centre country face portfolio constraints. In our model, international transmission occurs through the terms of trade, through the common discount factor for cash flows, and, finally, through an additional channel reflecting the tightness of the portfolio constraints. Portfolio constraints are shown to generate endogenous wealth transfers to or from the Periphery countries. These implicit transfers are responsible for creating contagion among the terms of trade of the Periphery countries, as well as their stock market prices. Under a portfolio constraint limiting investment of the Centre country in the stock markets of the Periphery, stock prices also exhibit a flight to quality: a negative shock to one of the Periphery countries depresses stock prices throughout the Periphery, while boosting the stock market in the Centre.
Keywords: Asset Pricing; Contagion; International Finance; Portfolio Constraints; Terms of Trade
JEL Codes: F31; F36; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| portfolio constraints in the center country (G15) | endogenous wealth transfers to the periphery countries (F16) |
| endogenous wealth transfers to the periphery countries (F16) | improves terms of trade in the periphery (F14) |
| endogenous wealth transfers to the periphery countries (F16) | boosts stock market prices in the periphery (G10) |
| tightening of portfolio constraints in the center country (F32) | negatively impacts center country's stock market prices (F65) |
| negative shock to one of the periphery countries (F69) | flight to quality (L15) |
| flight to quality (L15) | stock prices throughout the periphery decline (G10) |
| flight to quality (L15) | boosts center country's stock market (G15) |
| portfolio constraints (G11) | amplify shocks (E32) |
| portfolio constraints (G11) | affect comovement of stock prices among periphery countries (E44) |
| portfolio constraints (G11) | decrease comovement of stock prices between periphery and center country (F29) |