Working Paper: CEPR ID: DP6647
Authors: Anna Pavlova; Roberto Rigobon
Abstract: We study the comovement among stock prices and among exchange rates in a three-good three-country Centre-Periphery dynamic equilibrium model in which the Centre?s agents face portfolio constraints. We characterize equilibrium in closed form for a broad class of portfolio constraints, solving for stock prices, terms of trade, and portfolio holdings. We show that portfolio constraints generate wealth transfers between the Periphery countries and the Centre, which increase the comovement of the stock prices across the Periphery. We associate this excess comovement caused by portfolio constraints with the phenomenon known as contagion. The model generates predictions consistent with other important empirical results such as amplification and flight-to-quality effects.
Keywords: Asset Pricing; Contagion; International Finance; Portfolio Constraints; Terms of Trade; Wealth Transfer
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 (G11) | Wealth Transfers between Peripheral Countries and the Center (F16) |
| Wealth Transfers between Peripheral Countries and the Center (F16) | Amplified Stock Price Fluctuations (G17) |
| Portfolio Constraints (G11) | Increased Comovement of Stock Prices across Peripheral Countries (F65) |
| Tightened Portfolio Constraints (G11) | Wealth Transfer from the Center to the Periphery (F16) |
| Wealth Transfer from the Center to the Periphery (F16) | Decline in the Center's Stock Market (N22) |
| Wealth Transfer from the Center to the Periphery (F16) | Depressed Stock Prices of the Periphery (E32) |
| Tightening of Portfolio Constraints (G11) | Capital Withdrawals from Peripheral Markets (F32) |
| Capital Withdrawals from Peripheral Markets (F32) | Further Price Drops in Peripheral Stocks (D41) |
| Capital Withdrawals from Peripheral Markets (F32) | Increased Correlation among Peripheral Stock Returns (G19) |
| Tightened Portfolio Constraints (G11) | Increased Correlation of Stock Returns between Peripheral Countries (F65) |
| Tightened Portfolio Constraints (G11) | Decreased Correlation of Stock Returns with the Center (G19) |