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This study tests for financial contagion impact of the US Subprime crisis on Gulf economies both theoretically and empirically. Theoretically, it investigates the possible connections that could move the Subprime crisis to the Gulf market, by identifying the bridge of channels between the US and GCC countries. Fundamental channels: the securitization, oil channel and some other commons shocks like the Fed interest rate and the US dollar. Psychological channels: the herding behavior due to the shift in investor sentiment which is manifested by the massive liquidation and capital outflows. Empirically, Gaussian Copula has been used to analyze the change in dependence structure from the pre-crisis to the crisis period. Results show significant level of contagion in Kuwait, Dubai stock markets and Saudi market which displays the strongest level. Contagion signs should be taken into consideration by the portfolio managers (ineffectiveness of the diversification strategies) Our results can be handy for Gulf central banks who decide for the bailout. Some limits: Theoretically: Lack of transparency and sophistication in gulf markets Empirically: one Gaussian copula out of many was adopted basing on graphical insight.
Citation preview
The contagious Effect of the US Subprime Crisis on Gulf Countries
Presented by Sana Khelifi
MASTER’S THESIS IN ACTUARIAL & FINANCIAL SCIENCES
2
‘When the United States sneezes, the rest of the world may well catch a cold’ – By Rich Miller
Presentation Outline
Motivation
Literature Review
Contagion channels of the Subprime Crisis
Evidence of contagion: Gaussian Copula
Caveats and Conclusion
3
Motivation
Since the 1990s, we’ve experienced numerous financial crises:
The Exchange Rate Mechanism attack – 1992 -93 East Asian crises – 1997 Russian Collapse and LTCM – 1998 Brazilian devaluation – 1999 IT bubble - 2000-01 US Sub-prime mortgage crisis – 2007 Aftermath of sub-prime mortgage crises – Early 2008-
09!! Each crisis spreads around like a contagious disease
sometimes without any fundamental explanation4
MotivationContagion? The situation in which a faltering economy in one country
causes otherwise healthy economies in other countries to have financial problems
“..a significant increase in cross-market linkages after a shock to one country (or group of countries)” – Forbes & Rigobon (2001)
Subprime, Contagion…Gulf? The Subprime crisis although originated in a very
specific and relatively small segment of the US mortgage market, it has spread across the borders.
The limited gulf exposure to Subprime instruments (S&P).5
MotivationGulf Stock Market Crash
Gulf as an oil-based state?
Oil prices fell over 75%
6
Gulf Stock market fell over 40 %
KSE
ADIDFM
TASI
MotivationSubprime Crisis – Oil freefall
KSE
ADIDFM
TASI
7
Oil prices fell over 75%
Gulf as an oil-based state?
Motivation
Is the US Subprime Crisis contagious to Gulf Market??
What are the potential channels that could move
the US Subprime to Gulf market?
Assuming the definition of Forbes & Rigobon, is
there any significant change in dependence
structure between US and Gulf market after the
Subprime burst?8
Literature Review Fundamental-Based Contagion (non-crisis contingent theories)
It consists of real linkages and interdependencies that already
exist before crisis:
Trade links: country crisis effect on its trading partners’
accounts
Financial links: cross-country investments
Common and random shocks: interest rate surge, oil prices
volatility…
Policy coordination: effect of a member country shock on
other members 9
Literature Review
Pure /Psychological Contagion (crisis
contingent theories)
It consists of channels that differ from those before crisis:
Multiple Equilibrium - Change in investor’s
expectation
Endogenous Liquidity shocks - Portfolio re-allocation
Political contagion 10
Literature ReviewDetection method of contagion?
Fundamental-based contagion measures : Testing the significance of each fundamental transmission channel using binary
probit model - Eichengreen and al. (1996) Pure contagion measures: Testing the structural change in
transmission mechanisms
GARCH & ARCH models – testing the volatility spillover across
market - Edwards (1998)
Dependence measures – testing the change in dependencies after
shock
• Pearson’s linear correlation - King and Wadhwani (1990)
• Conditional correlation - shift contagion - Forbes & Rigobon
(2000)
• Copula approach – Paulo et al. (2009) & Rodriguez (2006)
11
Subprime Contagion: Fundamental-based contagion
Financial links – The securitization and its domino effect
SubprimeSubprime BorrowerBorrower
SubprimeSubprime LenderLender
SPVSPV
InvestorsInvestors
Banks
Hedge Funds Insurance Companies
Pension Funds
Housing Prices DeclineARM resets
Mortgage Loans
Sales of loans LoansProceeds
Stop Repayment: Mortgage Delinquencies & Foreclosures
Mortgage Cash Flow declines
-Losses on MBS & CDO-CDS Losses -Asset Prices Collapse-Wave of Corporate defaults-Meltdown in the "Shadow financial
system"-Drying-up of liquidity and capital=> Vicious circle of losses, capital fall,
and credit tightening forced the liquidation and fire sales of assets at below fundamental prices
Securitization
12
Fundamental-based contagion - Financial links
GCC credit default swapsGCC real estate price index
Gulf Banks Write-downs
272
740
1200
966
446
0 200 400 600 800 1000 1200 1400
Abu Dhabi Commercial Bank
Gulf Investment Corp.
Gulf International Bank
Arab Banking Corporation
Gulf Bank, Kuwait
Million $
Gulf Sovereign Wealth Funds Losses
Dec 2008 Estimates
-41%
-40%
-36%
-30%
-12%
-50% -40% -30% -20% -10% 0%
ADIA
KIA
Norwegian Oil Fund
QIA
SAMA
13
GRC
IMF
IMF
GRC
IMF
IMF
Fundamental Based-contagion Trade Links
-2000
-1500
-1000
-500
0
500
1000
1500
NorthAmerica
Europe FormersSoviet Union
Middle East Asia LatinAmerica
Africa
2007 2008 2009
Source: IEA
Oil demand down,…
Fundamental-based contagion Common Aggregate shock
The Fed Interest rate hike
rising of spreads and finance costs, Loans Defaults –
Credit default swaps hike
Weak US dollar - GCC currencies peg to US dollar
Oil prices fall - Gulf as oil-based states
Growing Inflation
15
Pure / Psychological contagion
Gulf investors sensitivity to signs of economic weakness
Change In Stock Market Indices
-73%
-57%
-50%
-49%
-47%
-46%
-44%
-42%
-80% -70% -60% -50% -40% -30% -20% -10% 0%
Dubai
Saudi Arabia
Qatar
Oman
Kuwait
S&P500
Abu Dhabi
Bahrain
16
IMF
Evidence of contagion - Gaussian Copula
Data: daily return indices issued from the US stock
market and three other GCC markets: S&P500, DFM, KSE
and TASI index
Period: 1st of January 2005 to the 05th of February 2009
Numbers of Observations:
Programming tool: Matlab (v 7.0)
S&P500 DFM KSE TASI
Total Nos. of Obs.
1031 1097 1055 1089
Pre-crisis. Nos. 649 729 663 715
Crisis Nos. 382 368 392 374
17
Data analysis
Daily return indices
18
Data analysis
Descriptive Statistics
Histograms goodness of fit
S&P500 DFM KSE TASI
Mean. -0.0003 -0.00029 -0.00017 -0.00012
Std. 0.0146 0.0179 0.0079 0.0186
KurtosisSkewness
16.1492-0.345
10.9134-0.0132
9.4178-0.7957
9.4983-0.7822
19
-0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.150
20
40
60
80
100histogramme DMF
-0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05 0.060
20
40
60
80
100histogramme KSE
-0.15 -0.1 -0.05 0 0.05 0.10
20
40
60
80
100
120histogramle TASI
-0.1 -0.05 0 0.05 0.1 0.150
50
100
150
200histogramme SP500
Methodology
Select the Univariate Distribution Functions
appropriate for each index: We test the Gaussian & t-
student functions
Select the appropriate copula to Join the marginal
distributions taken in step1
Divide the series into two sub-periods: “pre-crisis
period” and “crisis period”
Estimate the parameters of the selected copula taken
in step 2
and compare between the pre-crisis and crisis period.20
Results
T-student function has been selected as the adequate univariate distributions for all of the indices (as shown the qqplot below and as per the Maximum likelihood
estimations)
21
-0.1 -0.05 0 0.05 0.1
0.00010.00050.001 0.005 0.01 0.05 0.1 0.25 0.5 0.75 0.9 0.95 0.99 0.995 0.999 0.99950.9999
Data
Pro
bability
DMF data
Normalestudent
-0.1 -0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08
0.00010.00050.001 0.005 0.01
0.05 0.1
0.25
0.5
0.75 0.9 0.95
0.99 0.995 0.999 0.99950.9999
DataP
robability
TASI data
Normal TASIStudent TASI
-0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05
0.00010.00050.001 0.005 0.01
0.05 0.1 0.25
0.5
0.75 0.9 0.95
0.99 0.995 0.999 0.99950.9999
Data
Pro
bability
KSE data
StudentNormal
-0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1
0.00010.00050.001 0.005 0.01 0.05 0.1 0.25 0.5 0.75 0.9 0.95 0.99 0.995 0.999 0.99950.9999
Data
Pro
bability
SP data
Normal SPstudent SP
Results
Gaussian Copula has been selected as per the scatter plot of indices.
• The set of points is highly
concentrated and centered
•The scatter of the points seems to
be relatively alike in the left and
upper tail 22
SP500 vs DMF
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%
SP500
DM
F
SP500 vs TASI
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%
SP500
TA
SI
SP500 vs KSE
-5.00%
0.00%
5.00%
10.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%
SP500
KS
E
Results
Based on the fundamental event (burst of the subprime bubble) and the empirical perception shown below, the 1st of August 2007 has been chosen as the structural break date separating between the pre-crisis period and the crisis period.
23
Results
Copula parameters have increased significantly from the pre-crisis to crisis period for all the indices under investigation.
Saudi Market displays stronger signs of contagion
There is an evidence for the presence of contagion between the American Market and the Gulf markets under investigation.
Estimated copula parameters
Whole period Pre-crisis
periodCrisis period
DFM 0.0257 -0.037 0.0772
KSE 0.0379 0.0044 0.0772
TASI 0.0505 -0.0119 0.1285
24
Caveats and Conclusion
This study tests for financial contagion impact of the US Subprime
crisis on Gulf economies both theoretically and empirically.
Theoretically, it investigates the possible connections that could
move the Subprime crisis to the Gulf market, by identifying the
bridge of channels between the US and GCC countries.
Fundamental channels: the securitization, oil channel and some
other commons shocks like the Fed interest rate and the US dollar.
Psychological channels: the herding behavior due to the shift in
investor sentiment which is manifested by the massive liquidation
and capital outflows.
25
Caveats and Conclusion
Empirically, Gaussian Copula has been used to analyze the
change in dependence structure from the pre-crisis to the crisis
period. Results show significant level of contagion in Kuwait,
Dubai stock markets and Saudi market which displays the
strongest level.
Contagion signs should be taken into consideration by the
portfolio managers (ineffectiveness of the diversification
strategies)
Our results can be handy for Gulf central banks who decide for the
bailout.
Some limits:
Theoretically: Lack of transparency and sophistication in gulf
markets
Empirically: one Gaussian copula out of many was adopted basing
on graphical insight.
26