Abstract
We examine the statistical properties of daily changes in emerging market bond spreads
over US treasuries, and simulate an agent-based model to attempt to replicate those properties.
The actual data indicate that changes in spreads: 1) are definitely not normally distributed,
exhibiting much fatter tails; 2) are serially correlated, suggesting deviation from market
efficiency; and 3) exhibit excessive co-movement, suggesting contagion. A simple model of
interacting traders produces alternating booms and crashes, as in reality, but is not capable of
producing fat-tailed distributions or contagion. We focus on an extended model with market
makers whose bid/asked spreads widen with increased volatility and the size of their inventory.
This model highlights the role of liquidity (or lack of it) in explaining large rate movements and
contagion.
The Brookings Institution is committed to quality, independence, and impact.
We are supported by a diverse array of funders. In line with our values and policies, each Brookings publication represents the sole views of its author(s).
