Detecting Financial Collapse and Ballooning Sovereign Risk
| Author | Shuping Shi,Peter C. B. Phillips |
| Date | 01 December 2019 |
| DOI | http://doi.org/10.1111/obes.12307 |
| Published date | 01 December 2019 |
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©2019 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 81, 6 (2019) 0305–9049
doi: 10.1111/obes.12307
Detecting Financial Collapse and Ballooning
Sovereign Risk*
Peter C. B. Phillips† and Shuping Shi‡
†Cowles Foundation for Research in Economics, Yale University, Box 208281, New Haven,
CT 06520-8281, USA (e-mail: peter.phillips@yale.edu)
‡Department of Economics, Macquarie University, North Ryde Sydney, NSW 2109,
Australia (e-mail: shuping.shi@mq.edu.au)
Abstract
This paper proposes a new model for capturing discontinuities in the underlying financial
environment that can lead to abrupt falls, but not necessarily sustained monotonic falls,
in asset prices. This notion of price dynamics is consistent with existing understanding
of market crashes, which allows for a mix of market responses that are not universally
negative. The model may be interpreted as a martingale composed with a randomized
drift process that is designed to capture various asymmetric drivers of market sentiment. In
particular, the model is capable of generating realistic patterns of price meltdowns and bond
yield inflations that constitute major market reversals while not necessarily being always
monotonic in form. The recursive and moving window methods developed in Phillips,
Shi and Yu (2015a,b; PSY), which were designed to detect exuberance in financial and
economic data, are shown to have detective capacity for such meltdowns and expansions.
This characteristic of the PSY tests has been noted in earlier empirical studies by the present
authors and other researchers but no analytic reasoning has yet been given to explain why
methods intended to capture the expansionary phase of a bubble may also detect abrupt and
broadly sustained collapses. The model and asymptotic theory developed in the present
paper together explain this property of the PSY procedures. The methods are applied
to analyse S&P 500 stock prices and sovereign risk in European Union countries over
2001–16 using government bond yields and credit default swap (CDS) premia. A pseudo
real-time empirical analysis of these data showsthe effectiveness of the monitoring strategy
in capturing key events and turning points in market risk assessment.
I. Introduction
Crashes are often defined in terms of an abrupt discontinuity in the relationship between the
underlying financial environmentand stock prices that produces an unusually large negative
JEL Classification numbers: C23.
*Phillips acknowledgesresearch suppor t from the KellyFund, University of Auckland. Shi acknowledges research
support from the Australian Research Council [project number DP150101716].
Financial collapse and sovereign risk 1337
movement in asset prices (Gennotte and Leland, 1990; Barlevy andVeronesi, 2003; Hong
and Stein, 2003). Abrupt movements in market prices of this type may well produce a
major initial unidirectional change but are seldom monotonic for a sustained period, a
phenomenon that complicates modelling and econometric inference. In this regard, market
collapses share a common feature with the expansionary phase of most bubbles.
The occurrence of financial market crashes may be due to significant news events
or reported changes in fundamentals. The sudden and disruptive re-pricing of Euro area
sovereign credit risk in 2008–12 is a vividexample. Starting with Ireland in late September
2008, Euro area governments announced a set of rescue packages. These measures com-
monly took the form of capital injections and guarantees for financial sector liabilities and
purchases of illiquid assets from financial institutions, all intended to increase confidence
in their banking systems. According to the International Monetary Fund, as of 15 April
2009, the total support for the financial sector in Ireland reached a level of 2.63 times its
2008 GDP.1While the effect of these fiscal interventions on national economies is more
difficult to measure, it is clear that the interventions led to significant deteriorations in
budget positions and a ballooning of government debt. The average upfront financing need
cited in the IMF report for the Euro countries in April 2009 was around 5% of 2008 GDP,
and upfront Government financing in the UK exceeded 20%. The resulting negative shock
to the public sector caused tremendous falls in government bond prices, with bond yields
and credit default swaps soaring to record highs over the immediate years following the
crisis, particularly in Southern European countries.
On the other hand, many of the dramatic crashes in the US stock market – most notably
the 1929 and 1987 crashes – are documented to occur without any particular significant
news events or fundamental changes (Cutler, Poterba and Summers, 1989; Gennotte and
Leland, 1990).There is a vast literature providing alternative explanations for crash discon-
tinuities in stock prices. For example, Gennotte and Leland (1990) show that in a market
where uninformed investors are unable to distinguish hedging activity from information-
based trades, large numbers of such investors may revise downward their expectations
when there are what appear to be infinitesimal shifts in information or other small shocks
that lead to lower prices. The pessimistic view of the market limits their willingness to
absorb the extra supply and causes a magnified price response. In a behavioural model
with heterogeneous traders that take exuberant, cautious and neutral views of the same
fundamentals, Phillips (2016) shows that price solution paths may alternate between exu-
berance and collapse, depending on the relative proportions of such traders. Small shifts
alone in these proportions can have a major impact on market direction.
Barlevy andVeronesi (2003) showthat, even in the absence of hedging strategies such as
stop-loss strategies and portfolio insurance, uninformed traders can in some circumstances
precipitate a price crash. In related work, Romer (1993) and Hong and Stein (2003) consider
a market environment where investors possess diverse useful information about fundamen-
tals. The models proposed by Romer (1993) and Hong and Stein (2003) share a common
spirit that the trading process causes endogenous revelation of private information, which
in turn can lead to large price changes based on only small observable news events when
many investorsare affected. In a similar manner, Cont and Wagalath (2013, 2016) note that
1http://www.imf.org/external/np/fad/2009/042609.htm.
©2019 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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