The contagious Effect of the US Subprime Crisis on Gulf Countries Presented by  Sana Khelifi MASTER’S THESIS IN ACTUARIAL ...
‘ When the United States sneezes, the rest of the world may well catch a cold’  – By Rich Miller
Presentation Outline <ul><li>Motivation </li></ul><ul><li>Literature Review </li></ul><ul><li>Contagion channels of the Su...
Motivation <ul><li>Since the 1990s, we’ve experienced numerous financial crises: </li></ul><ul><ul><li>The Exchange Rate M...
Motivation <ul><li>Contagion? </li></ul><ul><li>The situation in which a faltering economy in one country causes otherwise...
Motivation <ul><li>Gulf Stock Market Crash </li></ul><ul><ul><ul><ul><li>Gulf as an oil-based state? </li></ul></ul></ul><...
Motivation <ul><li>Subprime Crisis – Oil freefall </li></ul>KSE ADI DFM TASI Oil prices fell over 75% <ul><ul><ul><ul><li>...
Motivation <ul><li>Is the US Subprime Crisis contagious to Gulf Market?? </li></ul><ul><ul><li>What are the potential chan...
Literature Review <ul><li>Fundamental-Based Contagion  (non-crisis contingent theories) </li></ul><ul><li>It consists of r...
Literature Review <ul><li>Pure /Psychological Contagion  (crisis contingent theories) </li></ul><ul><li>It consists of cha...
Literature Review <ul><li>Detection method of contagion?  </li></ul><ul><li>Fundamental-based contagion measures  : Testin...
Subprime Contagion: Fundamental-based contagion <ul><ul><li>Financial links – The securitization and its domino effect </l...
Fundamental-based contagion - Financial links GCC credit default swaps GCC real estate price index GRC IMF IMF GRC IMF IMF
Fundamental Based-contagion  Trade Links Source: IEA Oil demand down,…
Fundamental-based contagion    Common Aggregate shock   <ul><li>The Fed Interest rate hike </li></ul><ul><li>rising of spr...
Pure / Psychological contagion  <ul><li>Gulf investors sensitivity to signs of economic weakness  </li></ul>IMF
Evidence of contagion - Gaussian Copula <ul><li>Data :  daily return indices issued from the US stock market and three oth...
Data analysis <ul><li>Daily return indices   </li></ul>
Data analysis <ul><li>Descriptive Statistics   </li></ul><ul><li>Histograms goodness of fit </li></ul>S&P500 DFM KSE TASI ...
Methodology <ul><li>Select the Univariate Distribution Functions appropriate for each index: We test the Gaussian & t-stud...
Results <ul><li>T-student function has been selected as the adequate univariate distributions for all of the indices (as s...
Results <ul><li>Gaussian Copula has been selected as per the scatter plot of indices . </li></ul><ul><li>The set of points...
Results <ul><li>Based on the  fundamental event (burst of the subprime bubble)  and the  empirical perception  shown below...
Results <ul><li>Copula parameters have increased significantly from the pre-crisis to crisis period for all the indices un...
Caveats and Conclusion <ul><li>This study tests for financial contagion impact of the US Subprime crisis on Gulf economies...
Caveats and Conclusion <ul><li>Empirically, Gaussian Copula has been used to analyze the change in dependence structure fr...
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The Contagious Effect Of The US Subprime Crisis On Gulf Countries

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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.

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The Contagious Effect Of The US Subprime Crisis On Gulf Countries

  1. 1. The contagious Effect of the US Subprime Crisis on Gulf Countries Presented by Sana Khelifi MASTER’S THESIS IN ACTUARIAL & FINANCIAL SCIENCES
  2. 2. ‘ When the United States sneezes, the rest of the world may well catch a cold’ – By Rich Miller
  3. 3. Presentation Outline <ul><li>Motivation </li></ul><ul><li>Literature Review </li></ul><ul><li>Contagion channels of the Subprime Crisis </li></ul><ul><li>Evidence of contagion: Gaussian Copula </li></ul><ul><li>Caveats and Conclusion </li></ul>
  4. 4. Motivation <ul><li>Since the 1990s, we’ve experienced numerous financial crises: </li></ul><ul><ul><li>The Exchange Rate Mechanism attack – 1992 -93 </li></ul></ul><ul><ul><li>East Asian crises – 1997 </li></ul></ul><ul><ul><li>Russian Collapse and LTCM – 1998 </li></ul></ul><ul><ul><li>Brazilian devaluation – 1999 </li></ul></ul><ul><ul><li>IT bubble - 2000-01 </li></ul></ul><ul><ul><li>US Sub-prime mortgage crisis – 2007 </li></ul></ul><ul><ul><li>Aftermath of sub-prime mortgage crises – Early 2008-09!! </li></ul></ul><ul><ul><li>Each crisis spreads around like a contagious disease </li></ul></ul><ul><ul><li> sometimes without any fundamental explanation </li></ul></ul>
  5. 5. Motivation <ul><li>Contagion? </li></ul><ul><li>The situation in which a faltering economy in one country causes otherwise healthy economies in other countries to have financial problems </li></ul><ul><li>“ ..a significant increase in cross-market linkages after a shock to one country (or group of countries)” – Forbes & Rigobon (2001) </li></ul><ul><li>Subprime, Contagion…Gulf? </li></ul><ul><li>The Subprime crisis  although originated in a very specific and relatively small segment of the US mortgage market, it has spread across the borders. </li></ul><ul><li>The limited gulf exposure to Subprime instruments (S&P). </li></ul>
  6. 6. Motivation <ul><li>Gulf Stock Market Crash </li></ul><ul><ul><ul><ul><li>Gulf as an oil-based state? </li></ul></ul></ul></ul>Oil prices fell over 75% Gulf Stock market fell over 40 % KSE ADI DFM TASI
  7. 7. Motivation <ul><li>Subprime Crisis – Oil freefall </li></ul>KSE ADI DFM TASI Oil prices fell over 75% <ul><ul><ul><ul><li>Gulf as an oil-based state? </li></ul></ul></ul></ul>
  8. 8. Motivation <ul><li>Is the US Subprime Crisis contagious to Gulf Market?? </li></ul><ul><ul><li>What are the potential channels that could move the US Subprime to Gulf market? </li></ul></ul><ul><ul><li>Assuming the definition of Forbes & Rigobon, is there any significant change in dependence structure between US and Gulf market after the Subprime burst? </li></ul></ul>
  9. 9. Literature Review <ul><li>Fundamental-Based Contagion (non-crisis contingent theories) </li></ul><ul><li>It consists of real linkages and interdependencies that already exist before crisis: </li></ul><ul><ul><li>Trade links: country crisis effect on its trading partners’ accounts </li></ul></ul><ul><ul><li>Financial links: cross-country investments </li></ul></ul><ul><ul><li>Common and random shocks: interest rate surge, oil prices volatility… </li></ul></ul><ul><ul><li>Policy coordination: effect of a member country shock on other members </li></ul></ul>
  10. 10. Literature Review <ul><li>Pure /Psychological Contagion (crisis contingent theories) </li></ul><ul><li>It consists of channels that differ from those before crisis: </li></ul><ul><ul><li>Multiple Equilibrium - Change in investor’s expectation </li></ul></ul><ul><ul><li>Endogenous Liquidity shocks - Portfolio re-allocation </li></ul></ul><ul><ul><li>Political contagion </li></ul></ul>
  11. 11. Literature Review <ul><li>Detection method of contagion? </li></ul><ul><li>Fundamental-based contagion measures : Testing the significance of each fundamental transmission channel using binary probit model - Eichengreen and al. (1996) </li></ul><ul><li>Pure contagion measures: Testing the structural change in transmission mechanisms </li></ul><ul><ul><li>GARCH & ARCH models – testing the volatility spillover across market - Edwards (1998) </li></ul></ul><ul><ul><li>Dependence measures – testing the change in dependencies after shock </li></ul></ul><ul><ul><ul><ul><li>Pearson’s linear correlation - King and Wadhwani (1990) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Conditional correlation - shift contagion - Forbes & Rigobon (2000) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Copula approach – Paulo et al. (2009) & Rodriguez (2006) </li></ul></ul></ul></ul>
  12. 12. Subprime Contagion: Fundamental-based contagion <ul><ul><li>Financial links – The securitization and its domino effect </li></ul></ul>Subprime Borrower Subprime Lender SPV Investors Banks Hedge Funds Insurance Companies Pension Funds Housing Prices Decline ARM resets Mortgage Loans Sales of loans Loans Proceeds Stop Repayment: Mortgage Delinquencies & Foreclosures Mortgage Cash Flow declines <ul><ul><li>Losses on MBS & CDO </li></ul></ul><ul><ul><li>CDS Losses </li></ul></ul><ul><ul><li>Asset Prices Collapse </li></ul></ul><ul><ul><li>Wave of Corporate defaults </li></ul></ul><ul><ul><li>Meltdown in the &quot;Shadow financial system&quot; </li></ul></ul><ul><ul><li>Drying-up of liquidity and capital </li></ul></ul><ul><ul><li>=> Vicious circle of losses, capital fall, and credit tightening forced the liquidation and fire sales of assets at below fundamental prices </li></ul></ul>Securitization
  13. 13. Fundamental-based contagion - Financial links GCC credit default swaps GCC real estate price index GRC IMF IMF GRC IMF IMF
  14. 14. Fundamental Based-contagion Trade Links Source: IEA Oil demand down,…
  15. 15. Fundamental-based contagion Common Aggregate shock <ul><li>The Fed Interest rate hike </li></ul><ul><li>rising of spreads and finance costs, Loans Defaults – Credit default swaps hike </li></ul><ul><li>Weak US dollar - GCC currencies peg to US dollar </li></ul><ul><li>Oil prices fall - Gulf as oil-based states </li></ul><ul><li>Growing Inflation </li></ul>
  16. 16. Pure / Psychological contagion <ul><li>Gulf investors sensitivity to signs of economic weakness </li></ul>IMF
  17. 17. Evidence of contagion - Gaussian Copula <ul><li>Data : daily return indices issued from the US stock market and three other GCC markets: S&P500, DFM, KSE and TASI index </li></ul><ul><li>Period : 1st of January 2005 to the 05th of February 2009 </li></ul><ul><li>Numbers of Observations : </li></ul><ul><li>Programming tool : Matlab (v 7.0) </li></ul>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
  18. 18. Data analysis <ul><li>Daily return indices </li></ul>
  19. 19. Data analysis <ul><li>Descriptive Statistics </li></ul><ul><li>Histograms goodness of fit </li></ul>S&P500 DFM KSE TASI Mean. -0.0003 -0.00029 -0.00017 -0.00012 Std. 0.0146 0.0179 0.0079 0.0186 Kurtosis Skewness 16.1492 -0.345 10.9134 -0.0132 9.4178 -0.7957 9.4983 -0.7822
  20. 20. Methodology <ul><li>Select the Univariate Distribution Functions appropriate for each index: We test the Gaussian & t-student functions </li></ul><ul><li>Select the appropriate copula to Join the marginal distributions taken in step1 </li></ul><ul><li>Divide the series into two sub-periods: “pre-crisis period” and “crisis period” </li></ul><ul><li>Estimate the parameters of the selected copula taken in step 2 </li></ul><ul><li>and compare between the pre-crisis and crisis period. </li></ul>
  21. 21. Results <ul><li>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 ) </li></ul>
  22. 22. Results <ul><li>Gaussian Copula has been selected as per the scatter plot of indices . </li></ul><ul><li>The set of points is highly concentrated and centered </li></ul><ul><li>The scatter of the points seems to be relatively alike in the left and upper tail </li></ul>
  23. 23. Results <ul><li>Based on the fundamental event (burst of the subprime bubble) and the empirical perception shown below, the 1 st of August 2007 has been chosen as the structural break date separating between the pre-crisis period and the crisis period. </li></ul>
  24. 24. Results <ul><li>Copula parameters have increased significantly from the pre-crisis to crisis period for all the indices under investigation. </li></ul><ul><li>Saudi Market displays stronger signs of contagion </li></ul><ul><li>There is an evidence for the presence of contagion between the American Market and the Gulf markets under investigation. </li></ul>Estimated copula parameters Whole period Pre-crisis period Crisis period DFM 0.0257 -0.037 0.0772 KSE 0.0379 0.0044 0.0772 TASI 0.0505 -0.0119 0.1285
  25. 25. Caveats and Conclusion <ul><li>This study tests for financial contagion impact of the US Subprime crisis on Gulf economies both theoretically and empirically. </li></ul><ul><li>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. </li></ul><ul><li> Fundamental channels: the securitization, oil channel and some other commons shocks like the Fed interest rate and the US dollar. </li></ul><ul><li> Psychological channels: the herding behavior due to the shift in investor sentiment which is manifested by the massive liquidation and capital outflows. </li></ul>
  26. 26. Caveats and Conclusion <ul><li>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. </li></ul><ul><li>Contagion signs should be taken into consideration by the portfolio managers (ineffectiveness of the diversification strategies) </li></ul><ul><li>Our results can be handy for Gulf central banks who decide for the bailout. </li></ul><ul><li>Some limits: </li></ul><ul><li> Theoretically: Lack of transparency and sophistication in gulf markets </li></ul><ul><li> Empirically: one Gaussian copula out of many was adopted basing on graphical insight. </li></ul>

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