Working Paper: NBER ID: w15850
Authors: Yacine Atsahalia; Julio Cachodiaz; Roger J.A. Laeven
Abstract: Adverse shocks to stock markets propagate across the world, with a jump in one region of the world seemingly causing an increase in the likelihood of a different jump in another region of the world. To capture this effect mathematically, we introduce a model for asset return dynamics with a drift component, a volatility component and mutually exciting jumps known as Hawkes processes. In the model, a jump in one region of the world or one segment of the market increases the intensity of jumps occurring both in the same region (self-excitation) as well as in other regions (cross-excitation). The model generates the type of jump clustering that is observed empirically. Jump intensities then mean-revert until the next jump. We develop and implement an estimation procedure for this model. Our estimates provide evidence for self-excitation both in the US market as well as in other world markets. Furthermore, we find that US jumps tend to get reflected quickly in most other markets, while statistical evidence for the reverse transmission is much less pronounced. Implications of the model for measuring market stress, risk management and optimal portfolio choise are also investigated.
Keywords: Financial Contagion; Jump Processes; Hawkes Processes; Asset Returns; Market Dynamics
JEL Codes: C13; C32; G01; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse shocks in stock markets (G10) | contagion effect (E44) |
| a jump in one market (G10) | future jumps in that market (G10) |
| a jump in one market (G10) | future jumps in other markets (G19) |
| jumps in the US market (G10) | jumps in other global markets (F69) |
| jumps in other global markets (F69) | jumps in the US market (G10) |
| intensity of jumps (C41) | mean-reverts until the next jump occurs (C22) |