Abstract

This study examines the financial contagion among G-7 countries during the subprime credit crisis from July 2007 through December 2008. Specifically, we investigate the excess comovements of stock indices of the banking sectors of G-7 countries. We examine innovations - the component which cannot be explained by the fundamental factors - of the banking sector indices of G-7 countries. Innovations are defined as the residuals from the regression of banking sector indices on a set of explanatory variables using GARCH. We use eight macroeconomic variables and the return of a global stock index to capture the fundamental effects. We identify the excess comovement evidenced by the fact that the estimated innovation of one country significantly affects the stock indices of the other countries. However, we find no evidence that the explanatory power of estimated innovation increases during the subprime crisis, which suggests that the subprime crisis does not trigger excess comovement. Furthermore, we employ correlation coefficient tests. We estimate the innovation using VAR models, controlling for the aforementioned fundamental variables. We then examine the correlation coefficients of estimated innovations among G-7 countries. We do not find any evidence that the excess comovements significantly increase during the subprime crisis. Hence, our study does not support the notion that the subprime crisis triggered financial contagion in the banking sectors of G-7 countries.