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Federal Reserve Bank of San Francisco
Working Paper Series
When in peril, retrench: testing the portfolio channel of contagion
Fernando Broner
Gaston Gelos
Carmen M. Reinhart
Abstract

One plausible mechanism through which financial market shocks may propagate across countries is through the effect of past gains and losses on investors’ risk aversion. The paper first presents a simple model examining how heterogeneous changes in investors’ risk aversion affects portfolio decisions and stock prices. Second, the paper shows empirically that, when funds’ returns are below average, they adjust their holdings toward the average (or benchmark) portfolio. In other words, they 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 discusses a matrix of financial interdependence reflecting the extent to which countries share overexposed funds. Comparing this measure to indices of trade or bank linkages indicates that our index can improve predictions about which countries are likely to be affected by contagion from crisis centers.


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Fernando Broner & Gaston Gelos & Carmen M. Reinhart, When in peril, retrench: testing the portfolio channel of contagion, Federal Reserve Bank of San Francisco, Working Paper Series 2004-28, 2004.
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Keywords: Risk ; Investments
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