Transmission Of Financial Stress Under Regime Switching

A general consensus among studies focusing on the transmission of crises from advanced economies to emerging markets indicates that the extent of pass-through of financial stress is linked to the depth of financial linkages between advanced and emerging economies. Using the Financial Stress Index (FSI) database developed by Balakrishnan et al (2009), the present paper attempts to investigate the financial transmission from a particular advanced economy, namely the USA, to an emerging economy from MENA region, namely Egypt. The investigation of particular interactions between a single advanced economy's financial component variables and the FSI of emerging economy within a regime-switching framework constitutes the major feature of this study that distinguish it from earlier works. Rather than ascribing the intensity of the index to some pre-set zero-one type of classification, the Markov switching approach allows the flexibility of an endogenously defined, thus data-dependent intensity. Monthly observations covering 2001.7-2009.10 periods are utilized in this study. Preliminary findings indicates that linearity of FSI series can be rejected in favor of the 2-regime Markov Switching framework. Among explanatory variables, the TED spread defined as the difference between US interbank rates and the yield on Treasury bills, the U.S stock market returns, U.S stock market volatility have all been found influential in driving up the Egyptian FSI. On the other hand, foreign exchange market volatility defined as month of month growth rate of USD turned out to be insignificant.