An analysis of contagion among Asian countries using the canonical model of contagion

Understanding the dependence among economies is relevant to policy makers, central banks and investors in the decision-making process. One important issue for study is the existence of contagion among economies. This work considers the Canonical Model of Contagion by Pesaran and Pick (Journal of Economic Dynamics and Control, 2007), which differentiates contagion from interdependence. The ordinary least squares estimator of this model is biased by the endogenous variables in the model. In this study, instrumental variables are used to decrease the bias of the ordinary least squares estimator. The model is extended to the case of heteroskedastic errors, features that are generally found in financial data. We postulate the conditional volatility of the performance indices as instrumental variables and analyze the validity of these instruments using Monte Carlo simulations. Monte Carlo simulations estimate the distributions of the estimators under the null hypothesis. Finally, the canonical model of contagion is used to analyze the contagion among seven Asian countries.