Econometric issues in the analysis of contagion

This paper presents a canonical, econometric model of contagion and investigates the conditions under which contagion can be distinguished from interdependence. In a two-market set-up it is shown that for a range of fundamentals the solution is not unique, and for sufficiently large values of the contagion coefficients it has interesting bifurcation properties with bimodal density functions. The identification of contagion requires that the equations for the individual markets contain market specific regressors. This sheds doubt on the general validity of the correlation-based tests of contagion recently proposed in the literature which do not involve any market specific variables. Furthermore, we show that ignoring endogeneity and interdependence can introduce an upward bias in the estimate of the contagion coefficient, and using Monte Carlo experiments we further show that this bias could be substantial. Finally, we analyse data on European interest rate spreads during the ERM and find a clear asymmetry in the contagion effects of sharp rises and falls; with only the former having some statistically significant effects.