DP4338 Fundamentals and Joint Currency Crises

Author(s): Casper G de Vries, Philipp Hartmann, Stefan Straetmans
Publication Date: March 2004
Keyword(s): asymptotic dependence, currency market linkages, financial crises, fundamentals, heavy tails
JEL(s): C49, F31, G12, G39
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4338

In this note we demonstrate that in affine models for bilateral exchange rates, the nature of return interdependence during crises depends on the tail properties of the fundamentals? distribution. We denote crisis linkages as either strong or weak, in the sense that the dependence remains or vanishes asymptotically. We show that if one currency return reaches crisis levels, the probability that the other currency breaks down as well vanishes asymptotically if the fundamentals? distributions exhibit light tails (like, for example, the normal). If, however, the marginal distributions exhibit heavy tails, the probability that the other currency breaks down as well remains strictly positive even in the limit. This result implies that linearity and heavy tails are sufficient conditions for joint or contagious currency crises to happen systematically through fundamentals.