Modeling contagion in the Eurozone crisis via dynamical systems

Castellacci, Giuseppe; Choi, Youngna

doi:10.1016/j.jbankfin.2014.05.013

Cited by 19 publications

(7 citation statements)

References 10 publications

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“…In parallel, the ECB's posture that all Eurozone-wide sovereign debt bears virtually no risk (as evidenced by its stance on risk capital regulation and as liquidity provider, see Castellacci and Choi, 2005) allowed market participants to presume that cross-border liabilities would be guaranteed, either via government intervention and international bail-out programmes; or indeed that risk differentials had been factored out completely (Sbracia and Zaghini, 2001). Consequently, financial institutions increased their exposure to the PIIGS, while the ability to contain potential contagious damage was decreasing (Castellacci and Choi, 2015). It is in the nature of markets that the refinancing difficulties of a single nation cause participants to re-evaluate their perceptions of other nations, and their reactions are the drivers of contagion (Bekaert et al, 2011;Missio and Watzka, 2011).…”

Section: Conceptual and Empirical Issuesmentioning

confidence: 99%

Will the crisis “tear us apart”? Evidence from the EU

Pappas

Ingham

Izzeldin

et al. 2016

International Review of Financial Analysis

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We examine the synchronisation of the European Union (EU) financial markets before and during the 2007 global financial crisis. We use an Asymmetric Dynamic Conditional Correlation (ADCC)-GARCH framework to control for the time-varying correlations and a Markov-Switching model to identify regime changes. Our sample considers 27 EU nations for the period 2000-2011. For each nation we formulate several characteristics of the crisis such as, synchronicity, duration and intensity measures. We find that the more recent EU members had a lagged entry to the crisis regime, were less adversely affected, show higher correlation between their stock markets and have their credit scores being revised more frequently relative to established EU members. We also find that higher levels of sovereign debt and lower levels of industrialisation positively impact crisis duration and intensity. Our results refute the notion of uniform integration of EU financial markets as evident from the highly non-synchronised observed crisis experience among the EU members. As such, one-size fits all policies are likely to be ineffective.

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Section: Conceptual and Empirical Issuesmentioning

confidence: 99%

Will the crisis “tear us apart”? Evidence from the EU

Pappas

Ingham

Izzeldin

et al. 2016

International Review of Financial Analysis

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“…Some recent literature, see for example [Aymanns and Farmer, 2015], has argued the presence of chaotic attractors in models of systemic risk in financial systems by means of numerical arguments. Then, [Choi and Douady, 2012] proposed a new instability indicator whose goal is capturing the chaotic dynamics of cash flows among financial institutions during turmoil periods, and [Castellacci and Choi, 2014] have modeled financial contagion in the Eurozone crisis with a similar aim.…”

Section: Discussionmentioning

confidence: 99%

“…using statistical models of past observations of investment prices; (v) finally our paper contributes to literature on the application of dynamical systems theory to the problem of systemic risk in financial markets Douady, 2012, Castellacci andChoi, 2014] and, specifically, to the study of the dynamics of leverage cycles and its relation with the financial regulation [Brunnermeier and Pedersen, 2009, Geanakoplos, 2010, Poledna et al, 2014, Aymanns and Farmer, 2015, Aymanns et al, 2016, Halling et al, 2016. Outline.…”

Section: Introductionmentioning

confidence: 96%

When Panic Makes You Blind: A Chaotic Route to Systemic Risk

2018

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We present an analytical model to study the role of expectation feedbacks and overlapping portfolios on systemic stability of financial systems. Building on [Corsi et al., 2016], we model a set of financial institutions having Value at Risk capital requirements and investing in a portfolio of risky assets, whose prices evolve stochastically in time and are endogenously driven by the trading decisions of financial institutions. Assuming that they use adaptive expectations of risk, we show that the evolution of the system is described by a slow-fast random dynamical system, which can be studied analytically in some regimes. The model shows how the risk expectations play a central role in determining the systemic stability of the financial system and how wrong risk expectations may create panic-induced reduction or over-optimistic expansion of balance sheets. Specifically, when investors are myopic in estimating the risk, the fixed point equilibrium of the system breaks into leverage cycles and financial variables display a bifurcation cascade eventually leading to chaos. We discuss the role of financial policy and the effects of some market frictions, as the cost of diversification and financial transaction taxes, in determining the stability of the system in the presence of adaptive expectations of risk.(1) Scuola Normale Superiore,

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“… Castellacci and Choi () employed a nonlinear program for subjective utility of wealth to characterize the evolution of wealth in a model of chaos theory that incoporates prospect theory. However, the instability criterion in their model is based on wealth elasticity characteristics.…”

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confidence: 99%

Noisy Chaos in a Large System of Decision‐Makers with Heterogeneous Beliefs with Application to Index Option Prices

Cadogan¹

2014

Syst. Res.

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Decision-makers (DMs) often exhibit preference reversal and phase transitions in their states of confidence. We show how those behaviors induce chaos in a large system of DMs with heterogeneous beliefs. We construct a behavioral matrix operator [from a DM's probability weighting function (PWF)] that characterizes a projective mapping of confidence in dual psychological spaces. Moreover, we prove that in a seemingly stable system of DMs, the empirical Lyapunov exponent process for the noisy orbit of DM deterministic PWFs admits tail event chaos controlled by risk attitude factors. We use reported results from rank-dependent Standard & Poor's 500 index option prices and Chicago Board Options Exchange Volatility Index to illustrate our theory. Data show phase transitions in the state of DM confidence over time as PWFs change from skew S-shape to inverted S-shape. Our model identifies an instability criterion function for the distribution of critical values of risk attitude factors over a convex set of probabilities bounded from above by the fixed-point probability for PWFs. In particular, we use the criterion function to estimate critical values for risk attitude factors in index option price data that predict market crash based on the orientation of the PWF implied by option data.

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Modeling contagion in the Eurozone crisis via dynamical systems

Cited by 19 publications

References 10 publications

Will the crisis “tear us apart”? Evidence from the EU

Will the crisis “tear us apart”? Evidence from the EU

When Panic Makes You Blind: A Chaotic Route to Systemic Risk

Noisy Chaos in a Large System of Decision‐Makers with Heterogeneous Beliefs with Application to Index Option Prices

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