| Abstract: | We investigate evidence of state-dependent correlation between Mexican Brady bond and Mexican Equity Fund returns between November 1990 and March 2000. During this timeframe, the Mexican capital market can be characterized by three distinct periods: pre-Peso crisis (November 1990–April 1993), the crisis years (May 1993–December 1996), and a period of recovery following the crisis. We find a statistical increase in correlation of returns from these instruments during the period surrounding the Peso crisis, and show that the correlation preceded the collapse of the Peso by 20 months. We also find that common fundamentals fail to explain the source of this correlation. However, using a regime switching model, state-dependent investor perceptions embedded in the Brady returns can explain the correlation pattern. Our evidence implies that time-varying correlation between debt and equity securities may be driven primarily by state-dependent investor perceptions about bond risk. |
