What is the Impact of Stock Market Contagion on an Investor's Portfolio Choice?
AbstractStocks 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 pape 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 InfoPaper provided by Department of Finance, Goethe University Frankfurt am Main in its series Working Paper Series: Finance and Accounting with number 198.
Date of creation: 2009
Date of revision:
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-03-07 (All new papers)
- NEP-RMG-2009-03-07 (Risk Management)
- NEP-UPT-2009-03-07 (Utility Models & Prospect Theory)
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