MODELING FINANCIAL CONTAGION USING MUTUALLY EXCITING JUMPPROCESSES

Adverse shocks to stock markets propagate across the world, with a jump in one region of the worldseemingly causing an increase in the likelihood of a different jump in another region of the world.To capture this effect mathematically, we introduce a model for asset return dynamics with a driftcomponent, a volatility component and mutually exciting jumps known as Hawkes processes. In themodel, a jump in one region of the world or one segment of the market increases the intensity of jumpsoccurring both in the same region (self-excitation) as well as in other regions (cross-excitation). Themodel generates the type of jump clustering that is observed empirically. Jump intensities then mean-revertuntil the next jump. We develop and implement an estimation procedure for this model. Our estimatesprovide evidence for self-excitation both in the US market as well as in other world markets. Furthermore,we find that US jumps tend to get reflected quickly in most other markets, while statistical evidencefor the reverse transmission is much less pronounced. Implications of the model for measuring marketstress, risk management and optimal portfolio choise are also investigated....