Working Paper: NBER ID: w10941
Authors: Fernando A. Broner; R. Gaston Gelos; Carmen M. Reinhart
Abstract: One plausible mechanism through which financial market shocks may propagate across countries is through the effect of past gains and losses on investors' risk aversion. The paper first presents a simple model examining how heterogeneous changes in investors' risk aversion affects portfolio decisions and stock prices. Second, the paper shows empirically that, when funds' returns are below average, they adjust their holdings toward the average (or benchmark) portfolio. In other words, they tend to sell the assets of countries in which they were "overweight", increasing their exposure to countries in which they were "underweight." Based on this insight, the paper discusses a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.
Keywords: No keywords provided
JEL Codes: F02; F30; F32; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| changes in investors' risk aversion (D11) | portfolio decisions (G11) |
| portfolio decisions (G11) | stock prices (G12) |
| funds experience below-average returns (G23) | adjust holdings (G11) |
| adjust holdings (G11) | sell assets in overexposed countries (G15) |
| adjust holdings (G11) | buy into underexposed countries (G15) |
| financial interdependence (F30) | stock market movements during crises (G01) |
| degree of financial interdependence (F30) | stock market performance (G10) |
| shared overexposure of funds (G23) | adverse effects during financial crises (G01) |