Transmission Channels of Financial Shocks to Stock, Bond, and Asset-Backed Markets : An Empirical Model

This book uses modern linear and nonlinear econometric methods to characterize how shocks to the yield of risky fixed income securities, such as sub-prime asset-backed or low-credit rating sovereign bonds, are transmitted to the yields in other markets. Researchers, policymakers and commentators have long debated the patterns through which adverse shocks in a few markets may quickly spread to a range of apparently disconnected financial markets causing widespread losses and turmoil. This book uses modern linear and non-linear econometric methods to characterize how shocks to the yield of risky fixed income securities, such as sub-prime asset-backed or low-credit rating sovereign bonds, are transmitted to the yields in other markets. These include equity and corporate bond markets as well as relatively risk-free fixed income securities, such as highly rated asset-backed securities and sovereign bonds from core Eurozone countries. The authors analyse and compare the results from linear and non-linear models to identify and assess four distinct contagion channels characterizing both US and European financial markets. These include the correlated information, risk premium, flight-to-liquidity, and flight-to quality channels. The results of this study support the theory that both investors and policy-makers ought to pay special attention to liquidity and commonalities in the perceptions of the probabilities of default, as channels through which financial shocks propagate Transmission Channels of Financial Shocks to Stock, Bond, and Asset-Backed Markets: An Empirical Model 4 Contents 6 List of Figures 7 List of Tables 8 Preface 9 1 The Background: Channels of Contagion in the US Financial Crisis 12 1.1 A brief review of the sequence of events during the US financial crisis 13 1.2 Modeling alternative cross-market contagion channels 17 Notes 21 2 Methodology 24 2.1 Vector autoregressive models 25 2.1.1 Reduced vs. structural forms 25 2.1.2 Estimation 27 2.1.3 Impulse response functions 28 2.2 Markov switching vector autoregressive models 30 2.2.1 The model 31 2.2.2 Estimation 34 2.2.3 Generalized impulse response functions for MS models 36 Notes 37 3 The Data 39 3.1 Asset-backed securities 40 3.2 The Treasury repo and Treasury bond markets 41 3.3 Corporate bonds 42 3.4 The equity market 42 3.5 Summary statistics 43 Notes 47 4 Estimates of Single-State VAR Models 49 4.1 Model selection 50 4.2 The VAR(2) model 53 Note 60 5 Results from Markov Switching Models 61 5.1 Model selection 62 5.2 A three-regime MSVAR model 66 5.2.1 Economic interpretation of the regimes 74 Notes 77 6 Estimating and Disentangling the Contagion Channels 79 6.1 A methodology to identify contagion channels 80 6.2 Overall patterns of financial contagion 83 6.3 The liquidity channel 89 6.4 The risk premium and flight-to-quality channels 91 6.5 The correlated information channel 100 Notes 103 7 Comparing the US and European Contagion Experiences 105 7.1 A European data set 106 7.2 Alternative channels of contagion in the European sovereign crisis 107 7.3 Cross-country, cross-market shocks: did the subprime crisis spill over to Europe? 120 Notes 128 8 Conclusions 130 References 135 Index 141 Researchers, policymakers and commentators have long debated the patterns through which adverse shocks in a few markets may quickly spread to a range of apparently disconnected financial markets causing widespread losses and turmoil. This book uses modern linear and non-linear econometric methods to characterize how shocks to the yield of risky fixed income securities, such as sub-prime asset-backed or low-credit rating sovereign bonds, are transmitted to the yields in other markets. These include equity and corporate bond markets as well as relatively risk-free fixed income securities, such as highly rated asset-backed securities and sovereign bonds from core Eurozone countries. The authors analyse and compare the results from linear and non-linear models to identify and assess four distinct contagion channels characterizing both US and European financial markets. These include the correlated information, risk premium, flight-to-liquidity, and flight-to quality channels. The results of this study support the theory that both investors and policy-makers ought to pay special attention to liquidity and commonalities in the perceptions of the probabilities of default, as channels through which financial shocks propagate.-- Provided by Publisher