Author: Avishek Bhandari
Date: 2026-05-05

# Methodology Guide

#### Avishek Bhandari

#### 2026-05-05

# Overview

`contagionchannels` operationalises a two-stage research design that is deliberately ecumenical about identification. Stage 1 detects directional information flow between markets using Wavelet-Quantile Transfer Entropy (WQTE). Stage 2 attributes the detected flow to five economically meaningful channels using a battery of estimators that lean on different identifying assumptions. This vignette walks through the conceptual machinery one layer at a time and points to the canonical references for each component.

    library(contagionchannels)

# 1. The detection-attribution distinction

A perennial confusion in the contagion literature is the elision of two quite different statistical questions:

1. Detection. Does country \(i\)’s return predict country \(j\)’s return beyond what is implied by their joint distribution at common factors?
2. Attribution. Through which channel (trade, finance, sentiment, geopolitics, monetary policy) does that predictive content travel?

Detection is a local, model-free question best answered with a flexible information-theoretic statistic; attribution is a structural question that requires explicit identifying restrictions. Conflating the two leads to the familiar problem in which a generic correlation spike is read as evidence of a particular causal channel. The two-stage design enforces a clean separation: the WQTE step asks only whether a flow exists; the IV/LP/Rigobon step asks which structural shock the flow embeds.

# 2. Stage 1: WQTE math intuition

The Stage 1 statistic combines three classical ingredients: Schreiber’s (2000) transfer entropy, the maximal-overlap discrete wavelet transform (MODWT) for scale-localisation, and conditional quantile filtering for tail sensitivity.

## Transfer entropy

For two stationary series \(X_t\) and \(Y_t\) Schreiber’s transfer entropy from \(X\) to \(Y\) is

\[ T_{X \to Y} \;=\; \sum p\!\left(y_{t+1}, y_t^{(k)}, x_t^{(\ell)}\right) \; \log \frac{p\!\left(y_{t+1} \mid y_t^{(k)}, x_t^{(\ell)}\right)} {p\!\left(y_{t+1} \mid y_t^{(k)}\right)}, \]

with \(y_t^{(k)} = (y_t, y_{t-1}, \dots, y_{t-k+1})\) and similarly for \(x_t^{(\ell)}\). Intuitively, \(T_{X \to Y}\) measures the bits per observation that knowing the past of \(X\) adds to the prediction of \(Y\) above and beyond \(Y\)’s own past.

## Wavelet decomposition

We pre-filter both series with the MODWT (Daubechies LA8) at dyadic scales \(s \in \{1,2,3,4,5,6\}\), producing band-pass returns \(W_{X,t}^{(s)}\) that isolate fluctuations of period \([2^{s}, 2^{s+1}]\) trading days. Scale \(s=5\) covers the 32-64 day band, which lines up with the quarterly business-cycle horizon that motivates most of the channel proxies.

## Quantile conditioning

Following Bekiros and co-authors, transfer entropy is computed conditional on the source being in a quantile bin. Define \(X_t^{(\tau)} = \mathbf{1}\{X_t \le Q_X(\tau)\}\) and replace \(X\) with \(X^{(\tau)}\) in the entropy expression above. We use \(\tau = 0.50\) as the default since the paper’s primary interest is the typical (median) flow, not just the tail.

## Bias correction

The WQTE point estimate \(\widehat{T}^{(s,\tau)}_{i \to j}\) is bias-corrected by Monte Carlo shuffling. We draw \(B = 100\) permutations of the source series, recompute the statistic, and subtract the mean. Statistical significance is then assessed by comparing the corrected statistic to the upper tail of the shuffled distribution.

    F_mat <- compute_wqte_matrix(
      returns   = my_returns_xts,
      scale     = 5,
      tau       = 0.50,
      n_cores = 1,
    )

References. Schreiber (2000) introduced transfer entropy (doi:10.1103/PhysRevLett.85.461). The wavelet implementation borrows from the `waveslim` package; quantile conditioning extends the Bekiros et al. quantile-cross-spectral approach.

# 3. Stage 2: why multi-method identification?

A point estimate from any single estimator can be artefactual. Different methods buy identification with different assumptions:

Method | Identifying assumption | Failure mode
--- | --- | ---
IV/2SLS | Channel-specific instruments are exogenous | Weak/invalid instruments
LASSO IV | Sparsity in the first stage | Approximate-sparsity violation
LP | Conditional mean linearity at each horizon | Non-linearity, regime change
Rigobon | Variance of structural shocks shifts across regimes | Insufficient variance shift

The package reports all four in parallel. A robust finding is one in which the dominant channel agrees across estimators; a fragile finding is one that survives only under a single identifying assumption.

# 4. IV/2SLS with channel-specific instruments

Following the Stock-Watson (2018) external-instruments tradition, we use one external proxy per channel:

\[ \widehat{F}_{i\to j,t} \;=\; \alpha + \sum_{c=1}^{5} \beta_c \, C_{c,t} + u_{i\to j,t}, \qquad C_{c,t} \;=\; \pi_c Z_{c,t} + v_{c,t}. \]

The instruments \(Z_{c,t}\) are: lagged Baltic Dry Index for Trade; lagged FRA-OIS spread for Financial; lagged GPR-Daily for Geopolitical; lagged VIX innovation for Behavioral; lagged shadow-rate surprises for Monetary_Policy. Standard errors are heteroskedasticity-robust and clustered at the directional-link level. Over-identification is assessed via the Sargan-Hansen J-test; periods with high rejection rates (GFC 67.3%, COVID 100%, ESDC 65.5%) are reported but demoted to exploratory.

    fit <- iv_2sls_attribute(
      returns_period  = returns_pc,
      channels_period = channels_pc,
      links           = links_pc,
      instruments     = list(
        Trade           = "BDI_lag",
        Financial       = "FRAOIS_lag",
        Geopolitical    = "GPR_lag",
        Behavioral      = "VIX_innov_lag",
        Monetary_Policy = "ShadowRate_surp_lag"
      ),
      cluster_se = TRUE
    )

Reference: Stock and Watson (2018) doi:10.1111/ecoj.12593.

# 5. LASSO instrument selection

When the candidate instrument list is long the Belloni-Chernozhukov-Hansen (2014) post-LASSO IV estimator is preferred. The first stage runs

\[ C_{c,t} = \pi_c' Z_t + v_{c,t}, \]

where \(Z_t\) is a high-dimensional vector of candidate instruments (macroeconomic surprises, policy-rate residuals, commodity shocks, etc.) and \(\pi_c\) is recovered via LASSO with the iteratively-tuned penalty loadings of Belloni et al. The selected instruments feed the second-stage 2SLS, and inference is conducted under the standard sparsity conditions \(s \log(p) / n \to 0\).

    fit_lasso <- lasso_iv_attribute(
      returns_period  = returns_pc,
      channels_period = channels_pc,
      links           = links_pc,
      candidate_Z     = candidate_instrument_grid,
      selection       = "post_lasso"
    )

Reference: Belloni, Chernozhukov and Hansen (2014) doi:10.1093/restud/rdt044.

# 6. Local projections

Jordà (2005) projections estimate impulse responses by direct OLS at each horizon \(h\):

\[ \widehat{F}_{i\to j,t+h} \;=\; \alpha_h + \beta_{c,h} \, C_{c,t} + \gamma_h' X_t + u_{i\to j,t+h}, \quad h \in \{1, 5, 22\}. \]

LP avoid the recursive bias of VAR-based IRFs and are robust to dynamic mis-specification, at the cost of larger standard errors at long horizons. We follow Stock-Watson and use Newey-West HAC standard errors with bandwidth \(h+1\).

    lp_fit <- local_projections(
      returns_period  = returns_pc,
      channels_period = channels_pc,
      links           = links_pc,
      horizons        = c(1, 5, 22),
      controls        = c("VIX_lag", "USD_lag")
    )

Reference: Jordà (2005) doi:10.1257/0002828053828518.

# 7. Rigobon heteroskedasticity-based identification

When external instruments are unavailable but shock variances shift across regimes, Rigobon (2003) provides identification through heteroskedasticity. Partition the sample into a high-volatility regime \(H\) and a low-volatility regime \(L\) (we use VIX terciles). The reduced-form covariance matrices satisfy

\[ \Omega_H - \Omega_L = A \,(\Sigma_H - \Sigma_L)\, A', \]

so that \(A\) is identified up to sign from the difference in covariance matrices, provided the structural shock-variance ratio differs across regimes. The package’s `rigobon_id()` function implements the GMM estimator with the analytical Jacobian.

    rig_fit <- rigobon_id(
      returns_period  = returns_pc,
      channels_period = channels_pc,
      links           = links_pc,
      regime_split    = "vix_high_low"
    )

Reference: Rigobon (2003) doi:10.1162/003465303772815727.

# 8. Cinelli-Hazlett robustness value

Identification-robust point estimates are not the end of the story: unobserved confounders may still be lurking. The Cinelli-Hazlett (2020) RV quantifies the minimum strength of an unobserved confounder, expressed as its partial \(R^2\) with both the treatment and the outcome, that would push the estimated coefficient to zero (the “tipping point” RV) or to its two-sided null (the “5% RV”):

\[ \mathrm{RV}_{q} \;=\; \frac{1}{2} \left( \sqrt{f_q^{4} + 4 f_q^{2}} - f_q^{2} \right), \quad f_q \;=\; \frac{|\hat{\theta}| - q \cdot \widehat{\mathrm{SE}}} {|\hat{\theta}| + q \cdot \widehat{\mathrm{SE}}}\cdot \sqrt{\mathrm{df}}. \]

A coefficient with \(\mathrm{RV} \ge 0.20\) is one that no plausible single-confounder explanation can overturn under reasonable benchmarks.

    rv <- cinelli_hazlett_rv(
      theta = fit$shares,
      se    = fit$se,
      df    = fit$df_residual
    )

Reference: Cinelli and Hazlett (2020) doi:10.1111/rssb.12348.

# 9. Identification-status classification

The decision rule used in the paper is intentionally conservative:

- Robust — dominant channel agrees across IV/2SLS, LP-h5 and Rigobon, Sargan rejection rate below 50%, and Cinelli-Hazlett \(\mathrm{RV} \ge 0.20\) for the dominant channel.
- Fragile — at least one of the three estimators disagrees on the dominant channel, or Sargan rejects in more than half of links, or \(\mathrm{RV} < 0.20\).
- Exploratory — Sargan rejection rate above 65% (GFC, COVID, ESDC). Reported but not used as primary evidence.

Out of the eight sub-periods, only Pre-Crisis (Financial) and ESDC (Financial) clear the bar for robust; the remaining six are reported as fragile, with the exploratory flag attached to GFC and COVID.

This explicit grading is what makes the package useful for empirical work: the user is never invited to mistake a single-method point estimate for a robust attribution claim. The codebase, vignettes, and the report objects returned by `run_contagion_pipeline()` propagate the identification status into every downstream summary table and figure.

# Session info

    sessionInfo()
    #> R version 4.1.2 (2021-11-01)
    #> Platform: x86_64-pc-linux-gnu (64-bit)
    #> Running under: Ubuntu 22.04.5 LTS
    #>
    #> Matrix products: default
    #> BLAS:   /usr/lib/x86_64-linux-gnu/blas/libblas.so.3.10.0
    #> LAPACK: /usr/lib/x86_64-linux-gnu/lapack/liblapack.so.3.10.0
    #>
    #> locale:
    #>  [1] LC_CTYPE=en_IN       LC_NUMERIC=C         LC_TIME=en_IN
    #>  [4] LC_COLLATE=C         LC_MONETARY=en_IN    LC_MESSAGES=en_IN
    #>  [7] LC_PAPER=en_IN       LC_NAME=C            LC_ADDRESS=C
    #> [10] LC_TELEPHONE=C       LC_MEASUREMENT=en_IN LC_IDENTIFICATION=C
    #>
    #> attached base packages:
    #> [1] stats     graphics  grDevices utils     datasets  methods   base
    #>
    #> other attached packages:
    #> [1] dplyr_1.1.4             xts_0.14.1              zoo_1.8-14
    #> [4] contagionchannels_0.1.3
    #>
    #> loaded via a namespace (and not attached):
    #>  [1] bslib_0.9.0        compiler_4.1.2     pillar_1.11.1      jquerylib_0.1.4
    #>  [5] tools_4.1.2        digest_0.6.37      tibble_3.3.0       jsonlite_2.0.0
    #>  [9] evaluate_1.0.5     lifecycle_1.0.5    lattice_0.20-45    pkgconfig_2.0.3
    #> [13] rlang_1.2.0        Matrix_1.5-4.1     igraph_2.2.0       cli_3.6.6
    #> [17] yaml_2.3.10        parallel_4.1.2     SparseM_1.84-2     xfun_0.53
    #> [21] fastmap_1.2.0      multitaper_1.0-17  knitr_1.50         generics_0.1.4
    #> [25] sass_0.4.10        vctrs_0.6.5        MatrixModels_0.5-1 tidyselect_1.2.1
    #> [29] grid_4.1.2         glue_1.8.0         R6_2.6.1           survival_3.2-13
    #> [33] waveslim_1.8.5     rmarkdown_2.30     magrittr_2.0.4     htmltools_0.5.8.1
    #> [37] MASS_7.3-55        splines_4.1.2      quantreg_6.1       cachem_1.1.0