Testing for Contagion: a Time-Scale Decomposition

The aim of the paper is to test for financial contagion by estimating a simultaneous equation model subject to structural breaks. For this purpose, we use the Maximum Overlapping Discrete Wavelet Transform, MODWT, to decompose the covariance matrix of four asset returns on a scale by scale basis. This decomposition will enable us to identify the structural form model and to test for spillover effects between country specific shocks during a crisis period. We distinguish between the case of the structural form model with a single dummy and the one with multiple dummies capturing shifts in the co-movement of asset returns occurring during periods of financial turmoil. The empirical results for four East Asian emerging stock markets show that, once we account for interdependence through an (unobservable) common factor, there is hardly any evidence of contagion during the 1997-1998 financial turbulence.