Investor Sentiment: Too Contagious to Ignore?

Abstract

This article empirically investigates the role of investor sentiment as a determinant of financial contagion during crises periods. The focus is on developed equity markets as well as emerging equity markets during 1990-2015. By using a multivariate GARCH methodology, cross-equity market correlations are documented to be substantially increasing during financial crises. Investor sentiment is negatively related cross-equity market correlation. This inverse relationship becomes even stronger during times of financial crises, indicating the existence of financial contagion. This finding can be motivated by loss-averse and ambiguity-averse investors in equity markets. The relationship between investor sentiment and cross-equity market correlation persists after controlling for trade linkages, financial linkages, and other macroeconomic similarities between countries. The findings are robust to changes in crises definition.