Crises, Contagion, and the Closed-End Country Fund Puzzle

In this paper, we analyze the behavior of closed-end country fund discounts during a period that covers the Mexican and the East Asian crises. We find that the ratio of country fund prices to their fundamental value increases dramatically during a financial crisis, an anomaly that we denote as the closed-end country fund puzzle. Our results show that the crisis premia are associated with the existence of a common (market sentiment) component of the evolution of fund prices across emerging markets, combined with significant declines in share prices in crisis countries. Thus, the puzzle is directly related to the fact that international investors are less (more) sensitive to changes in local (global) market conditions than domestic investors. While this asymmetric response implies that foreign participation in local markets can help dampen the effects of a financial crisis in the originating country, it also suggests that foreign investors can amplify the contagion to noncrisis countries