Contagion versus flight to quality in financial markets

Abstract

None doubts that financial markets are related (interdependent). What is not so clear is whether there exists contagion among them or not, its intensity, and its causal direction. The aim of this paper is to define properly the term contagion (different from interdependence) and to present a formal test for its existence, the magnitude of its intensity, and for its direction. Our definition of contagion lies on tail dependence measures and it is made operational through its equivalence with some copula properties. In order to do that, we define a NEW copula, a variant of the Gumbel type, that is sufficiently flexible to describe different patterns of dependence, as well as being able to model asymmetric effects of the analyzed variables (something not allowed with the standard copula models). Finally, we estimate our copula model to test the intensity and the direction of the extreme causality between bonds and stocks markets (in particular, the flight to quality phenomenon) during crises periods. We find evidence of a substitution effect between Dow Jones Corporate Bonds Index with 2 years maturity and Dow Jones Stock Price Index when one of them is through distress periods. On the contrary, if both are going through crises periods a contagion effect is observed. The analysis of the corresponding 30 years maturity bonds with the stock market reflects independent effects of the shocks.