Does linkage fuel the fire? The transmission of financial stress across the markets

Abstract

The full-text may be used and/or reproduced, and given to third parties in any format or medium, without prior permission or charge, for personal research or study, educational, or not-for-pro t purposes provided that:• a full bibliographic reference is made to the original source • a link is made to the metadata record in DRO • the full-text is not changed in any way The full-text must not be sold in any format or medium without the formal permission of the copyright holders.Please consult the full DRO policy for further details. AbstractThis paper develops an indicator of financial stress transmission, called Financial Stress Spillover Index (FSSI), to monitor the condition of financial system and to identify periods of excessive spillover that may lead to financial instability. Specifically, using the "spillover index" approach of Diebold and Yilmaz (2012), we modify and extend the financial stress indices proposed by Oet et al. (2011) to track both total and directional stress spillovers across the U.S. equity, debt, banking, and foreign exchange markets. Unlike other previous studies, the important linkages among these four major financial sectors in an interconnected world are directly taken into account by considering the average and time-varying connectedness of each individual market. The evidence suggests that there are important stress episodes and fluctuations across markets; the total cross-market stress spillovers were rather limited until the onsets of financial crises. As the crises intensified, so too did the financial stress spillovers; with significant stress carrying over from debt and equity markets to the others. In addition, our results indicate that FSSI has a significant predictive power for the economic activity and provides useful information for dating financial crisis. JEL classification: G01; C03

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“…Existing studies either focus on only constructing a financial stress index (FSI) for a country (i.e. Illing and Liu, 2006) or both on constructing and evaluating the link between financial stress and economic activity to examine how well FSI identifies known periods of financial distress (Cevik et al, 2013;Cardarelli et al, 2011;Chau and Deesomsak, 2014;Mallick and Sousa, 2013). There are also a few studies that consider financial stress transmission among countries (Balakrishnan et al, 2009;Park and Mercado Jr., 2014).…”

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