A Dynamic Conditional Correlation Analysis-Based Approach to Test Financial Contagion in Developing Markets

Abstract

This paper examines the contagion from US and Britain markets to Asian markets, namely, China, Japan, India, and Malaysia. The period of study spreads over 6 years from January 3, 2006, to December 19, 2011. We split the study period into three sub-periods which include: (1) pre-crisis period or quiet period from January 3, 2006, to July 31, 2007; (2) crisis period from August 1, 2007, to February 26, 2010; and (3) post-subprime crisis period from February 27, 2010, to December 19, 2011. The sub-periods have been taken based on the recommendations by Horta et al. (Contagion effects of the subprime crisis on developed countries, CEFAGE- UE working papers 2009/01, University of Evora, CEFAGE- UE, Portugal, 2009) and Naoui et al. (Int J Econ Financ 2(3):85–96, 2010a, J Bus Stud Q 2(1):15–28, 2010b). The significant change (increase) in the degree of correlation has been taken as a measure of contagion. We model the time-varying conditional correlation using bivariate dynamic conditional correlation generalized autoregressive conditional heteroskedasticity (DCC GARCH) model for all the three sub-periods separately for US-Asian market and Britain-Asian market pairs. We observe significant contagion effect from US and Britain stock markets to all Asian markets during the period of subprime crisis. However, after subprime crisis, we do not find any evidence of contagion from the USA to Japan and China and from Britain to China.