Managerial Incentives and Financial Contagion

This paper proposes a framework for comovements of asset prices with seemingly unrelated fundamentals, as an outcome of optimal portfolio strategies by fund managers. In emerging markets, dedicated managers outperforming a benchmark index and global managers maximizing absolute returns lead to systematic interactions between asset prices, without asymmetric information. The model determines optimal portfolio weights, the incidence of relative value strategies, and prices systematically deviating from fundamentals with limits to arbitraging this differential. Managerial compensation contracts, optimal at the firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when shocks in one emerging market affect others.Financial Crises, Index Investors, Global Linkages

The double play: simultaneous speculative attacks on currency and equity markets

This paper investigates the potential for foreign speculators to profit from simultaneously taking short positions in foreign exchange and equity markets under a fixed exchange rate regime, in what has been termed as the double play. Such a strategy is considered when the monetary authority is faced with two conflicting objectives exchange rate stability and low interest rates. While the monetary authority may not be able to directly intervene to stabilize interest rates under the fixed exchange rate regime, it may consider intervention in equity markets to head off speculative pressure on interest rates. The model determines market conditions where speculators may find the double play strategy profitable and the impact of government intervention on speculative short equity positions and the interest rate, concluding that intervention can never simultaneously reduce speculation in the equity and the money markets. In the case where country fundamentals are strong, intervention while reducing short positions in equity markets actually increases short positions in the money market and induces higher interest rates. The paper concludes by discussing the Hong Kong Monetary Authority's intervention in the Hong Kong equity market within the context of this model.Economic stabilization ; Foreign exchange rates ; Stock exchanges

Managerial incentives and financial contagion

This paper proposes a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers. In emerging markets, the dominant presence of dedicated fund managers whose compensation is linked to the outperformance of their portfolio relative to a benchmark index, and of global fund managers whose compensation is linked to the absolute returns of their portfolios, leads to portfolio decisions that result in systematic interactions between asset prices even in the absence of asymmetric information. The model endogenously determines the optimal amount of cash holdings or leverage, the incidence of relative value versus macro hedge fund strategies, and how prices can systematically deviate from the long-term fundamental value for long periods of time, with limits to the arbitrage of this differential. Managerial compensation contracts, while optimal at a firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when a negative shock to one emerging market affects another market negatively.Financial crises ; Mutual funds

COMOVEMENTS IN EMERGING MARKET BOND RETURNS: AN EMPIRICAL ASSESSMENT

The objective of the paper is to empirically assess the comovement of emerging bond returns of the key constituent countries of the EMBI Global benchmark Index since their introduction (broadly in 1997) up to the present. We aim at disentangling the respective roles of common external factors and "pure" contagion in the recent events of market spillovers. The unweighted average of cross-country rolling correlation coefficients, adjusted and unadjusted for the presence of common external factors, provides a first assessment of the joint behavior of emerging markets bond returns during the sample period. We furthermore show that the cross-country average correlations method may not be useful in summarizing market results if the underlying distribution of bond returns is not unimodal (i.e., if there are underlying groups that exhibit high within-group comovement but not between-group comovement). Several methods are used on a year-to-year basis in order to identify periods where the “two-tier paradigm” of emerging markets prevails. The analysis of correlation matrices enables us to identify groups of countries moving together during the recent events in emerging markets. These findings are further refined by performing Principal Component and Cluster Analysis. We provide a method in order to quantify the excess comovement common to all emerging countries as well as the country-specific one. Finally, we find evidence of “market tiering” and investors' discrimination especially during tranquil times: the first three quarters of 1997, from the third quarter of 1999 to the end of 2000 and from 2003 to 2005. We suggest that regional patterns and credit quality differentiation have an important role to play in the investors' discriminating behavior regarding the emerging bond markets whenever the period is free of strong and unforeseen shocks leading to spillover across countries and markets.emerging bond markets, excess comovement, contagion, market segmentation

Emerging Debt Markets: What Do Correlations and Spreads Tell Us?

This paper proposes a conceptual framework to identify the potential sources of contagion in emerging bond markets and the mechanisms through which shocks originating in a particular emerging or mature market are likely to be transmitted across countries and markets. We then apply this framework to the emerging countries initially included in the EMBI Global Index over the period 1997-2005. We put into light that emerging markets became less and less intertwined over the recent period, and that, at present, the risk of contagion may come mainly from events taking place into mature markets. Finally, we derive policy recommendations in order to reduce emerging countries debt variability thus making them less vulnerable to a shock that takes place in mature markets. Sound macroeconomic policies, and in particular, prudent fiscal ones, could enhance government discipline and limit contagion effects in a wake of a global shock or a shock affecting another emerging country.Emerging bond markets, International financial crises, Excess comovement, Contagion, Public debt

Korea’s near-Term economic prospects and challenges

노트 : A publication of the Korea Economic Institute and the Korea Institute for International Economic Polic

Emerging Debt Markets: What Do Correlations and Spreads Tell Us?

This paper proposes a conceptual framework to identify the potential sources of contagion in emerging bond markets and the mechanisms through which shocks originating in a particular emerging or mature market are likely to be transmitted across countries and markets. We then apply this framework to the emerging countries initially included in the EMBI Global Index over the period 1997-2005. We put into light that emerging markets became less and less intertwined over the recent period, and that, at present, the risk of contagion may come mainly from events taking place into mature markets. Finally, we derive policy recommendations in order to reduce emerging countries debt variability thus making them less vulnerable to a shock that takes place in mature markets. Sound macroeconomic policies, and in particular, prudent fiscal ones, could enhance government discipline and limit contagion effects in a wake of a global shock or a shock affecting another emerging country

Speculative Attacks, Forward Market Intervention and the Classic Bear Squeeze

A typical strategy used by speculators to launch an attack on a fixed exchange regime is the use of forward markets. Central banks also intervene in forward markets to counter speculation. This paper addresses the question of how an attack is launched on the forward market, and what the optimal policy response to such speculation is in the forward and spot markets. The paper also demonstrates how central banks can impose a bear squeeze on speculators. Recent events in South East Asian currency markets are interpreted within the framework of the model’s predictions.