Currency Crises, Contagion and Portfolio Selection

Abstract

Recent studies have shown evidence of asset market price correlation and contagion. For example, Karolyi and Stulz (1996) show evidence of co-movements of US and Japanese stock returns, and find large shocks to broad-based market indices positively affect both the magnitude and persistence of return correlations. Masson (1998) identifies several sources for contagion. In the so-called “monsoonal effect”, pressures common to affected assets are the source of the contagion. In the spillover effect, changes in fundamentals affecting one set of assets cause fundamental changes in other asset groups, leading to contagion. However, some observers (see, for example, Eichengreen and Mody, 1998) argue that these economic effects cannot fully explain contagion. In fact, a change in one set of asset prices may trigger changes elsewhere, for reasons unexplained by economic fundamentals, perhaps because there are shifts in the market’s attitude towards risk, leading to the notion of pure contagion.