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The effects of systemic crises when investors can be crisis ignorant

Author

Listed:
  • Kole, H.J.W.G.
  • Koedijk, C.G.
  • Verbeek, M.J.C.M.

Abstract

Systemic crises can largely affect asset allocations due to the rapid deterioration of the risk-return trade-off. We investigate the effects of systemic crises, interpreted as global simultaneous shocks to financial markets, by introducing an investor adopting a crisis ignorant or crisis conscious strategy. Including the possibility of a systemic crisis is a substantial improvement. Investments in risky assets fall, while allocations to countries less sensitive to a crisis grow relatively. An increasing probability of a crisis exacerbates these effects. The certainty equivalent costs of ignoring systemic crises are large, ranging from 0.65% per year unconditionally, to over 5% per month conditionally on a high probability for the occurrence of a crisis.

Suggested Citation

  • Kole, H.J.W.G. & Koedijk, C.G. & Verbeek, M.J.C.M., 2004. "The effects of systemic crises when investors can be crisis ignorant," ERIM Report Series Research in Management ERS-2004-027-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
  • Handle: RePEc:ems:eureri:1270
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    References listed on IDEAS

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    1. Carol Alexander & Sujit Narayanan, 2001. "Option Pricing with Normal Mixture Returns: Modelling Excess Kurtosis and Uncertanity in Volatility," ICMA Centre Discussion Papers in Finance icma-dp2001-10, Henley Business School, Reading University, revised Dec 2001.
    2. Andreas Graflund & Birger Nilsson, 2003. "Dynamic Portfolio Selection: the Relevance of Switching Regimes and Investment Horizon," European Financial Management, European Financial Management Association, vol. 9(2), pages 179-200.
    3. Carol Alexander & Andrew Scourse, 2004. "Bivariate normal mixture spread option valuation," Quantitative Finance, Taylor & Francis Journals, vol. 4(6), pages 637-648.
    4. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters?: A chronicle of the Asian crisis," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 537-560, August.
    5. Corsetti, Giancarlo & Pericoli, Marcello & Sbracia, Massimo, 2005. "'Some contagion, some interdependence': More pitfalls in tests of financial contagion," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1177-1199, December.
    6. Léonard,Daniel & Long,Ngo van, 1992. "Optimal Control Theory and Static Optimization in Economics," Cambridge Books, Cambridge University Press, number 9780521331586.
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    More about this item

    Keywords

    asset allocation; international finance; regime switching; systemic risk;

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • F30 - International Economics - - International Finance - - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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