The Changing Role of Financial Stress, Oil Price, and Gold Price in Financial Contagion among US and BRIC Markets

• Author: Ugur Soytas,Ramazan Sari,Ecenur Ugurlu,Baris Kocaarslan
• DOI: http://doi.org/10.1111/irfi.12189
• Published date: 01 September 2019
• Date: 01 September 2019

The Changing Role of Financial

Stress, Oil Price, and Gold Price in

Financial Contagion among US and

BRIC Markets

BARIS KOCAARSLAN

†

,UGUR SOYTAS

†

,RAMAZAN SARI

†

AND ECENUR UGURLU

‡

†

Department of Business Administration, Middle East Technical University, Ankara,

Turkey and

‡

Department of International Trade and Business, Yildirim Beyazit University, Ankara,

Turkey

ABSTRACT

The objective of this paper is to explore the determining factors behind

financial contagion between US and BRIC (Brazil, Russia, India, and China)

equity markets. To this end, we investigate the effects of global macroeco-

nomic factors on the time-varying correlations among these markets

obtained by asymmetric dynamic conditional correlation method. Utilizing

quantile regression analysis, we examine the determinants of financial conta-

gion at different levels of time-varying correlations. The results of quantile

regression analyses reveal that global financial crisis (GFC) (2008) leads to

changes in the dependence structure between dynamic conditional correla-

tions among equity markets and global macroeconomic factors, such as

global financial stress, oil prices, and gold prices. Following the GFC, mone-

tary, and fiscal policy changes in the BRIC markets and hence changing mac-

roeconomic risks of these markets are conducive to these changes. Our

findings also demonstrate the importance of cross-market rebalancing chan-

nel for information transmission across US and BRIC markets.

JEL Codes: F30; G15; C58

Accepted: 16 March 2018

I. INTRODUCTION

The spread of financial shocks from one country to others is called contagion.

The financial contagion among global markets has important consequences for

global market players, speculators, investors, and policy makers (Longin and

Solnik 1995; Ang and Bekaert 1999; Forbes and Rigobon 2002; Chiang

et al. 2007; Dooley and Hutchison 2009). The contagion literature reveals the

importance of two types of contagion: fundamental based-contagion and

investor-behavior contagion (Masson 1998; Dornbusch et al. 2000; Forbes and

Rigobon 2001). The former is related to contagion among markets based on

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 19:3, 2019: pp. 541–574

DOI: 10.1111/irfi.12189

trade and financial linkages between markets. Goldstein (1998) addresses

“wake-up call”hypothesis which argues that the fundamental characteristics of

countries may play an important role on financial contagion since investors

tend to reevaluate the susceptibility of a market to crises in other markets.

Bekaert et al. (2014) find evidence that wake-up calls drive financial contagion

during the global economic crisis (2008). The latter is caused by shifts in inves-

tors’risk appetites and risk perceptions, which lead to changes in the

asset allocation strategies of global investors. If there is an increase in the risk

appetite of global investors, investors are inclined to invest in more risky assets

in international markets. These trends lead to increases in the prices of risky

assets across global markets. This type of contagion is generated by changes in

global investors’portfolio structure rather than by the markets’characteristics

(Kumar and Persaud 2001).

The dynamic nature of information flows has an impact on market equilib-

rium prices and global portfolio diversification strategies. Fleming et al. (1998)

argue that not only common information simultaneously influences expecta-

tions across markets but also cross-market hedging leads to information spill-

overs. Investors who trade in the stock markets are affected by an information

event that directly or indirectly alters their expectations about a market. The

information flow arising from both common information and cross-market

hedging in return leads to increased linkages across markets. However, several

practical considerations and institutional constraints may limit the effect of

cross-market hedging (Fleming et al. 1998). Kodres and Pritsker (2002), in a

study on contagion channels, argue that financial contagion among global mar-

kets varies with their exposures to the shared macroeconomic risks and the

amount of information asymmetry in these markets. The tendency of rebalan-

cing global portfolios increases with the amount of information asymmetry

concerning risky markets, such as emerging markets where the amount of infor-

mation asymmetry is very high. Simultaneous trading activities resulting from

cross-market rebalancing enhance information linkages across equity markets

and ultimately generate financial contagion among them over time.

With the increase in globalization during the last decades, the correlations

between the risks of countries, global factors, and the stock markets’perfor-

mances have attracted a lot of interest (Forbes and Rigobon 2002; Abad

et al. 2010). Most of the studies in the literature show that the benefit of inter-

national diversification is reduced as more financial integration leads to an

increase in the correlations of global market returns (Longin and Solnik 1995).

Several studies investigate the time-varying cross-market correlations, especially

at the time of an economic crisis. During a crisis period, there are intensified

linkages among global markets (Cappiello et al. 2006; Aloui et al. 2011; Akca

and Ozturk 2016).

Although most of the early studies on contagion mainly focus on mature

markets rather than emerging markets, recently the number of studies on

emerging markets focusing on the time-varying cross-market correlations have

increased (Bekaert and Harvey 1995; Chen et al. 2002; Cappiello et al. 2006;

© 2018 International Review of Finance Ltd. 2018542

International Review of Finance

Carrieri et al. 2007.; Chiang et al. 2007; Kenourgios et al. 2011; Choe

et al. 2012). In fact, as De Jong and De Roon (2005) state, for the emerging mar-

kets, the dynamic nature of integration is more apparent than mature markets.

This may be due to the fact that they are progressively integrating into the

international markets. Time-varying nature of comovements across markets is

important for global portfolio management because it may have different impli-

cations for long-term- and short-term-oriented investment strategies of inves-

tors. Investors with different risk tolerances should consider time-varying

characteristics of correlations across market returns. Short-term dynamics

among markets concern active investors such as large investment banks

whereas the individuals, insurance companies, and commercial banks are more

interested in long-term dynamics between markets as passive investors

(Lehkonen and Heimonen 2014).

There have been several studies that identify important macroeconomic vari-

ables for equity returns and cash flows, such as business cycle patterns, future

production growth rates, dividend yields, and interest rates (Fama 1990; Schwert

1990; Longin and Solnik 1995). The role that global macroeconomic factors play

in determining the time series pattern of dynamic correlations across global mar-

kets has vital importance on hedging activity. The impacts of these macroeco-

nomic factors work via changes in investor expectations. Shifting funds across

global markets happens selectively when global investors expect information

linkages among markets to change over time based on the global conditions.

During the good times of global economies, the role of information asymmetry

in financial contagion could not be critical since global economic conditions are

stable, which likely leads to much less hedging activity (Kodres and Pritsker

2002). On the other hand, during the times of crisis, the increase in hedging

demand results in changes in correlation dynamics across global markets. But

the same is true for alternative markets. As global investors closely follow alter-

native investment areas, what happens in those markets may have significant

influences on how they form investors’expectations. Ultimately, a change in

the strategies followed by global investors will have an impact on the correla-

tions among global stock markets depending on investors’expectations.

There has been little research on the determinants of financial contagion

between markets. This study aims to shed light on the determinants of dynamic

correlations among US and BRIC (Brazil, Russia, India, and China) equity mar-

kets. To that respect, two alternative markets are taken into account. Several

important studies reveal that the gold market is sometimes considered as a safe

haven during turbulent periods (Jaffe 1989; Lawrence 2003; Arouri and Nguyen

2010; Baur and McDermott 2010; Daskalaki and Skiadopoulos 2011). In addi-

tion, the gold market can be considered as a representative of the precious

metals markets. The second alternative investment area is the oil market. There

is a huge literature on the links between oil and financial markets including

BRIC markets. This literature provides abundant evidence of price and volatility

spillovers between these markets (Bhar and Nikolova 2009; Kang et al. 2009;

Fang and You 2014). Oil can also be thought of as a leading commodity. Other

© 2018 International Review of Finance Ltd. 2018543

The Role of Global Factors in Financial Contagion