Financial contagion and tests using instrumental variables

This paper considers empirical tests for the contagion of financial crises that address the endogeneity of contagion by using instrumental variable estimation techniques. Two complications in the application to contagion are that the regression model is potentially incoherent and that it contains a parameter that is not identified under the null of no contagion. Monte Carlo experiments suggest that their influence is small in practice with the notable exception of similar tests, where both size and power are affected. An application to stock market data for the UK, USA, and Japan shows that ignoring the endogeneity of contagion leads to highly significant contagion coefficients. However, tests for contagion that takes the endogeneity into account result in mixed evidence for financial contagion.