NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

How Financial Crises Spread

"The authors find that during crises, emerging market funds engage in 'momentum trading,' selling stocks that recently declined and buying recent winners."

Like epidemics, financial crises tend to spread. Witness the 1997 Asian crisis, which quickly engulfed South Africa, Eastern Europe, and even Brazil. Many economists have argued that financial institutions sometimes panic, disregarding fundamentals, and thus spreading a crisis even to countries with strong fundamentals. Individual investors, too, can contribute to crisis by selling mutual funds, forcing fund managers to sell when the fundamentals do not warrant that action.

In Managers, Investors, and Crisis: Mutual Fund Strategies in Emerging Markets (NBER Working Paper No. 7855), authors Graciela Kaminsky, Richard Lyons, and Sergio Schmukler add to our understanding of this contagion-trading phenomenon by studying the behavior of U.S. international mutual funds focused in emerging markets. The authors find that during crises, emerging market funds engage in "momentum trading," selling stocks that recently declined and buying recent winners. Contemporaneous momentum trading is stronger during a financial crisis, and fund investors show a stronger inclination to engage in contemporaneous momentum trading than do fund managers.

Lagged momentum trading (buying past winners and selling past losers) is stronger during non-crisis periods and is stronger for fund managers than fund investors. The authors also find that funds engage in contagion trading, which they define as systematically selling assets from one country when asset prices begin to fall in another. This contagion trading is primarily attributable to investor activity, however, and not to the actions of fund managers.

The authors are able to distinguish in this study between fund investor trades (for example, fund inflows and outflows) and fund manager trades. They are also able to differentiate between momentum trading at the manager and investor levels. Their method of measuring contagion trading via transaction quantities is also new to the literature.

The datasets used by the authors include individual portfolios, which allow them to examine trading strategies at a high resolution. The data include information from 13 dedicated Latin American mutual funds from April1993 to January 1999. These 13 funds account for 88 percent of the total value of all 25 dedicated Latin American funds available as of the end of 1998.

-- Lucille Maistros


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