Bond Spreads, Market Integration and Contagion in the 2007-2008 Crisis

(ProQuest: ... denotes formulae omitted.)I. IntroductionMarket linkages are becoming increasingly important in the international environment. In particular, linkages in financial markets receive more attention during financial crisis as decision makers in markets become keener to receive available information across markets. The financial crisis, which began in 2007, is mainly a crisis in debt markets. For example, the market of mortgage-backed securities in the U.S. had been in extreme downturn since August 2007. In this paper, we study the nature of market integration and linkages around the period of recent financial crisis by analyzing bond spreads during the period.Yield spreads of bonds with the same maturity represents relative attractiveness of the bonds affected by profitability, default risk, and liquidity. These determinants of bond values are closely related to market connectedness and integration in the international environment. We need a multivariate specification to consider common shocks to bond spreads of multiple economies. We may need to consider heteroskedastic nature of volatilities of shocks. In these cases, the number of parameters to be estimated is usually very large. To avoid this curse of dimensionality and reduce the dimension of parameters, we use a latent factor model. This approach makes it possible to decompose observed volatility in bond spreads to various components with interpretable identification. The latent factor approach also has the advantage of quantifying the effects of contagion of shocks across markets.We consider four potential factors that influence bond spreads, as follows: the world factor, the regional factor, the country-specific factor, and the U.S. risk factor. The first, second and fourth factors are common factors. The third factor is country specific. The world factor captures the effect of worldwide events. In the period of seemingly worldwide boom before the 2007-2008 crisis, most countries were able to issue bonds under favorable conditions. The regional factor reflects common events in each region. Financial markets within each region are integrated to a certain degree among one another, and such integration often causes movements of markets in the same direction. For example, in the period of Asian economic crisis, many economies underwent similar adverse effects in their financial markets. The country specific factor affects only each country. For example, the credit card crisis in Korea in the early 2000s caused a slowdown of Korean economy but did not have noticeable effects on other economies or regions. The fourth factor is for the contagion channel of shocks originating from the U.S. in 2007-2008.The latent factor model describes dynamics of bond yield spreads with unobservable factors. This approach helps avoid modeling of a specific structure and allows us to absorb it in latent factors. Thus, this approach not only reduces the dimension of parameters to estimate but also avoids the problem of model misspecification. A number of authors use the latent factor model to analyze financial markets. Diebold and Nerlove (1989), Ng, Engle and Rothschild (1992), Mahieu and Schotman (1994), King, Sentana and Wadhwani (1994), and Forbes and Rigobon (2002) studied currency and equity markets based on the latent factor model. Gregory and Watts (1995) explored bond yields across countries. Dungey, Martin and Pagan (2000) applied a latent factor model to bond spreads. Kose, Otrok and Whiteman (2003) studied the common dynamic properties of business-cycle fluctuations across countries, regions, and the world based on a Bayesian dynamic latent factor model. The problem of transmission and contagion of financial crises has been studied by Dungey et al. (2011) based on the latent factor model.We analyzed data from 9 countries as follows: 3 Latin American countries (Argentina, Brazil, and Mexico), 3 Asian countries (Indonesia, Korea, and Philippines), and 3 developed countries (Japan, UK, and US). …