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What is the impact of stock market contagion on an investor's portfolio choice?

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  • Branger, Nicole
  • Kraft, Holger
  • Meinerding, Christoph
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    Abstract

    Stocks are exposed to the risk of sudden downward jumps. Additionally, a crash in one stock (or index) can increase the risk of crashes in other stocks (or indices). Our paper explicitly takes this contagion risk into account and studies its impact on the portfolio decision of a CRRA investor both in complete and in incomplete market settings. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time span between jumps in two stocks or stock indices, is thus of first-order importance when analyzing portfolio decisions. Investors ignoring contagion completely or accounting for contagion while ignoring its time dimension suffer large and economically significant utility losses. These losses are larger in complete than in incomplete markets, and the investor might be better off if he does not trade derivatives. Furthermore, we emphasize that the risk of contagion has a crucial impact on investors' security demands, since it reduces their ability to diversify their portfolios.

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    Bibliographic Info

    Article provided by Elsevier in its journal Insurance: Mathematics and Economics.

    Volume (Year): 45 (2009)
    Issue (Month): 1 (August)
    Pages: 94-112

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    Handle: RePEc:eee:insuma:v:45:y:2009:i:1:p:94-112

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    Web page: http://www.elsevier.com/locate/inca/505554

    Related research

    Keywords: Asset allocation Jumps Contagion Model risk;

    References

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    1. Liu, Jun & Pan, Jun, 2003. "Dynamic Derivative Strategies," Working papers 4334-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
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    Cited by:
    1. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2014. "Partial information about contagion risk, self-exciting processes and portfolio optimization," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 18-36.
    2. Konermann, Patrick & Meinerding, Christoph & Sedova, Olga, 2013. "Asset allocation in markets with contagion: The interplay between volatilities, jump intensities, and correlations," Review of Financial Economics, Elsevier, vol. 22(1), pages 36-46.

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