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

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  • Konermann, Patrick
  • Meinerding, Christoph
  • Sedova, Olga
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    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.

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    File URL: http://www.sciencedirect.com/science/article/pii/S105833001200050X
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    Bibliographic Info

    Article provided by Elsevier in its journal Review of Financial Economics.

    Volume (Year): 22 (2013)
    Issue (Month): 1 ()
    Pages: 36-46

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    Handle: RePEc:eee:revfin:v:22:y:2013:i:1:p:36-46

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    Web page: http://www.elsevier.com/locate/inca/620170

    Related research

    Keywords: Asset allocation; Portfolio choice; Contagion; Systemic risk; Regime switching;

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