When in peril, retrench: Testing the portfolio channel of contagion

One plausible mechanism through which financial market shocks may propagate across countries is through the impact that past gains and losses may have on investors’ risk aversion and behavior. This paper presents a stylized model illustrating how heterogeneous changes in investors’ risk aversion affect portfolio allocation decisions and stock prices. Our empirical findings suggest that when funds’ returns are below average, they adjust their holdings toward the average (or benchmark) portfolio. In so doing, funds tend to sell the assets of countries in which they were “overweight”, increasing their exposure to countries in which they were “underweight.” Based on this insight, the paper constructs an index of “financial interdependence” which reflects the extent to which countries share overexposed funds. The index helps in explain the pattern of stock market comovement across countries. Moreover, a comparison of this interdependence measure to indices of trade or commercial bank linkages indicates that our index can improve predictions about which countries are more likely to be affected by contagion from crisis centers.