Bloomberg.com
“An Asset-Pricing Model for the Contagion Age: Polson and Scott”
Dec. 7, 2011

In today’s inter-connected world, trouble in one country’s financial markets can easily cross borders, upsetting markets elsewhere around the globe.

While such turmoil raises investors’ blood pressure, it can provide opportunities for researchers. In the case of Europe’s ongoing financial crisis, Nicholas G. Polson, a professor of econometrics and statistics at the University of Chicago Booth School of Business, and James G. Scott, an assistant professor of statistics at the University of Texas at Austin McCombs School of Business, were able to use market disruptions to create new predictive tools:

In our work, we developed an asset-pricing model to study these market disruptions, which incorporates random shocks to volatility that are correlated across markets. It provides a more accurate way to evaluate contagion, defined as the extent to which shocks from one market affect another over and above the level implied by the underlying asset-pricing model.

The researchers explain:

Our asset-pricing model incorporates three volatility effects: cross-sectional clustering across countries (or markets), longitudinal clustering across time and directional clustering. These aren’t part of traditional models.

Cross-sectional clustering accounts for the observation that large market movements in one region seem to increase the chances of observing a large movement in another, beyond what would be predicted by traditional asset-pricing models.

Longitudinal clustering allows volatility shocks to persist over time, a well-known feature of such phenomena.

Directional clustering captures the fact that shocks in one market are often followed by shocks in a particular direction in another. That is, the event in the first market can be used to help predict the return in the other market. Our analysis finds that directional clustering has the greatest impact in predicting contagion between markets.

For more information about Polson and Scott’s work, the complete article is available at Bloomberg.com.