Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence

Abstract

This paper discusses a 'pure' form of financial contagion, unrelated to economic fundamentals -investors' shifting appetite for risk. It provides an analytical framework for identifying changes in investors' risk appetite and discusses whether it is possible to directly measure them in a way that can enable policy makers to differentiate between financial contagion and domestic fundamentals as the immediate source of a crisis. Daily measures of risk appetite are computed and their usefulness in predicting financial crises is assessed. *We are grateful to Natalia Alvarez-Grijalba, and Sreekala Kochugovindan, of State Street Bank, and to Ken Kashiwase for statistical support, and to Stephen Sprat for his contribution on the psychology of financial behaviour. We also thank two anonymous referees, Benn Steil, Montek

Global and Regional Financial Integration in Emerging Asia: Evidence from Stock Markets

“…Therefore, despite the declining level of global integration after the 2008 crisis, policy makers in the emerging Asian economies should have a framework in place to assess and monitor this type of transmission mechanism of financial crisis (e.g., the daily measures of risk appetite proposed by Kumar and Persaud (2002)) to be able to react quickly and effectively.…”

International Risk Tolerance, Capital Market Failure and Capital Flows to Emerging Markets

“…It is thus necessary to posit an explicit model of risk aversion-or its inverse, 'risk tolerance' or 'risk appetite' as it is known by market participants. Kumar and Persaud (2001) argue that most of the indicators used to proxy risk tolerance in the literature confuse the level of risk itself with risk tolerance: asset prices (or yield spreads) are in practice a function of both underlying risk and risk tolerance, this latter containing structural components (the underlying utility function and financial market structure) and a time varying element reflecting shorter-term factors such as so-called 'wake up calls'. 9 When these result from major collapses in emerging markets (such as the 1998 Russian crash), the effect on home risk appetite then affects other emerging markets through what is known as 'pure' contagion.…”

The Instability of the Emerging-Market Assets Demand Schedule

“…Kumar and Persaud (2001) suggest how this might be done, by arguing that observed spreads should not be explained in terms of the difference between global risk (α) and the variance of the asset price (σ 2 ) as is conventionally done, but rather the product of risk appetite (K) and the standard deviation of the asset price (P). This in turn defines the expected return E(R), which is measured as the difference between the long-term asset price LR(P) and the current price P.…”