IDEAS home Printed from https://ideas.repec.org/a/eee/revfin/v22y2013i1p36-46.html
   My bibliography  Save this article

Asset allocation in markets with contagion: The interplay between volatilities, jump intensities, and correlations

Author

Listed:
  • Konermann, Patrick
  • Meinerding, Christoph
  • Sedova, Olga

Abstract

We study the impact of financial contagion on the dynamic asset allocation problem of a CRRA investor facing an incomplete market with two risky assets. We apply a Markov chain regime-switching framework with state-dependent jump intensities, diffusion volatilities and diffusion correlations. The key model feature that a switch to the bad contagion regime is triggered by a loss in one of the risky assets allows for the implementation of a hedging demand against contagion risk. Moreover, a state-dependent diffusion correlation combined with heterogeneity in jump intensities and volatilities can, e.g., generate a flight to quality effect upon a systemic jump.

Suggested Citation

  • 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.
  • Handle: RePEc:eee:revfin:v:22:y:2013:i:1:p:36-46
    DOI: 10.1016/j.rfe.2012.08.001
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S105833001200050X
    Download Restriction: Full text for ScienceDirect subscribers only

    File URL: https://libkey.io/10.1016/j.rfe.2012.08.001?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Munk, Claus & Sorensen, Carsten, 2004. "Optimal consumption and investment strategies with stochastic interest rates," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1987-2013, August.
    2. Jun Tu, 2010. "Is Regime Switching in Stock Returns Important in Portfolio Decisions?," Management Science, INFORMS, vol. 56(7), pages 1198-1215, July.
    3. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
    4. Jun Liu & Francis A. Longstaff & Jun Pan, 2003. "Dynamic Asset Allocation with Event Risk," Journal of Finance, American Finance Association, vol. 58(1), pages 231-259, February.
    5. Markwat, Thijs & Kole, Erik & van Dijk, Dick, 2009. "Contagion as a domino effect in global stock markets," Journal of Banking & Finance, Elsevier, vol. 33(11), pages 1996-2012, November.
    6. Tim Bollerslev & Viktor Todorov, 2011. "Tails, Fears, and Risk Premia," Journal of Finance, American Finance Association, vol. 66(6), pages 2165-2211, December.
    7. Honda, Toshiki, 2003. "Optimal portfolio choice for unobservable and regime-switching mean returns," Journal of Economic Dynamics and Control, Elsevier, vol. 28(1), pages 45-78, October.
    8. Andrea Buraschi & Paolo Porchia & Fabio Trojani, 2010. "Correlation Risk and Optimal Portfolio Choice," Journal of Finance, American Finance Association, vol. 65(1), pages 393-420, February.
    9. Das, Sanjiv Ranjan & Sundaram, Rangarajan K., 1999. "Of Smiles and Smirks: A Term Structure Perspective," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(2), pages 211-239, June.
    10. Guidolin, Massimo & Timmermann, Allan, 2007. "Asset allocation under multivariate regime switching," Journal of Economic Dynamics and Control, Elsevier, vol. 31(11), pages 3503-3544, November.
    11. Kee-Hong Bae & G. Andrew Karolyi & René M. Stulz, 2003. "A New Approach to Measuring Financial Contagion," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 717-763, July.
    12. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2009. "What is the impact of stock market contagion on an investor's portfolio choice?," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 94-112, August.
    13. Liu, Jun & Pan, Jun, 2003. "Dynamic derivative strategies," Journal of Financial Economics, Elsevier, vol. 69(3), pages 401-430, September.
    14. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
    15. Kraft, Holger & Steffensen, Mogens, 2009. "Asset allocation with contagion and explicit bankruptcy procedures," Journal of Mathematical Economics, Elsevier, vol. 45(1-2), pages 147-167, January.
    16. Massimo Guidolin & Allan Timmermann, 2008. "International asset allocation under regime switching, skew, and kurtosis preferences," Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 889-935, April.
    17. Nicole M. Boyson & Christof W. Stahel & René M. Stulz, 2010. "Hedge Fund Contagion and Liquidity Shocks," Journal of Finance, American Finance Association, vol. 65(5), pages 1789-1816, October.
    18. Bjørn Eraker & Michael Johannes & Nicholas Polson, 2003. "The Impact of Jumps in Volatility and Returns," Journal of Finance, American Finance Association, vol. 58(3), pages 1269-1300, June.
    19. François Longin & Bruno Solnik, 2001. "Extreme Correlation of International Equity Markets," Journal of Finance, American Finance Association, vol. 56(2), pages 649-676, April.
    20. Branger, Nicole & Schlag, Christian & Schneider, Eva, 2008. "Optimal portfolios when volatility can jump," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 1087-1097, June.
    21. G. Andrew Karolyi, 2004. "Does International Financial Contagion Really Exist?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 16(2‐3), pages 136-146, March.
    22. Sanjiv Ranjan Das & Raman Uppal, 2004. "Systemic Risk and International Portfolio Choice," Journal of Finance, American Finance Association, vol. 59(6), pages 2809-2834, December.
    23. Michael J. Brennan & Yihong Xia, 2000. "Stochastic Interest Rates and the Bond-Stock Mix," Review of Finance, European Finance Association, vol. 4(2), pages 197-210.
    24. Ang, Andrew & Chen, Joseph, 2002. "Asymmetric correlations of equity portfolios," Journal of Financial Economics, Elsevier, vol. 63(3), pages 443-494, March.
    25. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-257, August.
    26. Kristin J. Forbes & Roberto Rigobon, 2002. "No Contagion, Only Interdependence: Measuring Stock Market Comovements," Journal of Finance, American Finance Association, vol. 57(5), pages 2223-2261, October.
    27. G. Andrew Karolyi, 2003. "Does International Financial Contagion Really Exist?," International Finance, Wiley Blackwell, vol. 6(2), pages 179-199, July.
    28. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2006. "Portfolio implications of systemic crises," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2347-2369, August.
    29. Kraft, Holger & Steffensen, Mogens, 2008. "How to invest optimally in corporate bonds: A reduced-form approach," Journal of Economic Dynamics and Control, Elsevier, vol. 32(2), pages 348-385, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Sofiane Aboura & Julien Chevallier, 2014. "Cross‐market spillovers with ‘volatility surprise’," Review of Financial Economics, John Wiley & Sons, vol. 23(4), pages 194-207, November.
    2. Dungey, Mardi & Flavin, Thomas J. & Lagoa-Varela, Dolores, 2020. "Are banking shocks contagious? Evidence from the eurozone," Journal of Banking & Finance, Elsevier, vol. 112(C).
    3. Anna Battauz & Alessandro Sbuelz, 2018. "Non†myopic portfolio choice with unpredictable returns: The jump†to†default case," European Financial Management, European Financial Management Association, vol. 24(2), pages 192-208, March.
    4. Sofiane Aboura & Julien Chevallier, 2014. "Cross-Market Spillovers with ‘Volatility Surprise’," Working Papers hal-04141310, HAL.
    5. repec:ipg:wpaper:2014-469 is not listed on IDEAS

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    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. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2009. "What is the impact of stock market contagion on an investor's portfolio choice?," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 94-112, August.
    3. Anna Battauz & Alessandro Sbuelz, 2018. "Non†myopic portfolio choice with unpredictable returns: The jump†to†default case," European Financial Management, European Financial Management Association, vol. 24(2), pages 192-208, March.
    4. Bruno Solnik & Thaisiri Watewai, 2016. "International Correlation Asymmetries: Frequent-but-Small and Infrequent-but-Large Equity Returns," PIER Discussion Papers 31., Puey Ungphakorn Institute for Economic Research, revised Jun 2016.
    5. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2006. "Portfolio implications of systemic crises," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2347-2369, August.
    6. Branger, Nicole & Muck, Matthias & Seifried, Frank Thomas & Weisheit, Stefan, 2017. "Optimal portfolios when variances and covariances can jump," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 59-89.
    7. Garcia, René & Tsafack, Georges, 2011. "Dependence structure and extreme comovements in international equity and bond markets," Journal of Banking & Finance, Elsevier, vol. 35(8), pages 1954-1970, August.
    8. Ji, Qiang & Liu, Bing-Yue & Cunado, Juncal & Gupta, Rangan, 2020. "Risk spillover between the US and the remaining G7 stock markets using time-varying copulas with Markov switching: Evidence from over a century of data," The North American Journal of Economics and Finance, Elsevier, vol. 51(C).
    9. Muck, Matthias, 2010. "Trading strategies with partial access to the derivatives market," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1288-1298, June.
    10. Kraft, Holger & Weiss, Farina, 2023. "Pandemic portfolio choice," European Journal of Operational Research, Elsevier, vol. 305(1), pages 451-462.
    11. Larsen, Linda Sandris & Munk, Claus, 2012. "The costs of suboptimal dynamic asset allocation: General results and applications to interest rate risk, stock volatility risk, and growth/value tilts," Journal of Economic Dynamics and Control, Elsevier, vol. 36(2), pages 266-293.
    12. Bruno Solnik & Thaisiri Watewai, 2016. "International Correlation Asymmetries: Frequent-but-Small and Infrequent-but-Large Equity Returns," PIER Discussion Papers 31, Puey Ungphakorn Institute for Economic Research.
    13. Chen, Ke & Vitiello, Luiz & Hyde, Stuart & Poon, Ser-Huang, 2018. "The reality of stock market jumps diversification," Journal of International Money and Finance, Elsevier, vol. 86(C), pages 171-188.
    14. José Afonso Faias & Juan Arismendi Zambrano, 2022. "Equity Risk Premium Predictability from Cross-Sectoral Downturns [International asset allocation with regime shifts]," The Review of Asset Pricing Studies, Oxford University Press, vol. 12(3), pages 808-842.
    15. Arouri, Mohamed & M’saddek, Oussama & Nguyen, Duc Khuong & Pukthuanthong, Kuntara, 2019. "Cojumps and asset allocation in international equity markets," Journal of Economic Dynamics and Control, Elsevier, vol. 98(C), pages 1-22.
    16. Nicole Branger & Matthias Muck & Stefan Weisheit, 2019. "Correlation risk and international portfolio choice," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(1), pages 128-146, January.
    17. Penaranda, Francisco, 2007. "Portfolio choice beyond the traditional approach," LSE Research Online Documents on Economics 24481, London School of Economics and Political Science, LSE Library.
    18. Bernd Scherer, 2020. "Alternative risk premia: contagion and portfolio choice," Journal of Asset Management, Palgrave Macmillan, vol. 21(3), pages 178-191, May.
    19. Maria Kasch & Massimiliano Caporin, 2013. "Volatility Threshold Dynamic Conditional Correlations: An International Analysis," The Journal of Financial Econometrics, Society for Financial Econometrics, vol. 11(4), pages 706-742, September.

    More about this item

    Keywords

    Asset allocation; Portfolio choice; Contagion; Systemic risk; Regime switching;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:revfin:v:22:y:2013:i:1:p:36-46. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/620170 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.