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

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.

Partial information about contagion risk, self-exciting processes and portfolio optimization

“…Kraft and Steffensen (2009) develop a similar model and apply it to the bond market, but focus on a complete market only. In contrast to our paper, Branger, Kraft, and Meinerding (2009) and Kraft and Steffensen (2009) assume that investors can observe the state of the economy perfectly. Ding, Giesecke, and Tomecek (2009) and Ait-Sahalia, Cacho-Diaz, and Laeven (2012) propose a different class of stochastic processes to model contagion effects, so-called selfexciting processes (Hawkes processes).…”

“…Some recent papers model contagion effects more explicitly. In this respect, our paper is related to Branger, Kraft, and Meinerding (2009). They focus on model risk and show that an investor modeling contagion using joint jumps can suffer severe utility losses once he is confronted with a Markov regime-switching framework.…”

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

“…In order to capture the time dimension of contagion, we follow Branger, Kraft, and Meinerding (2009) and consider a continuous‐time asset allocation model with two risky assets following jump‐diffusion processes and with two economic regimes, a calm and a contagion state. These regimes are governed by an underlying Markov chain.…”

“…To introduce contagion effects in our economy, we mainly follow Kraft and Steffensen (2009) and Branger et al (2009). However, Kraft and Steffensen (2009) investigate defaultable bonds instead of stocks with the risk of downward price jumps.…”

Partial Information about Contagion Risk and Portfolio Choice

“…In this respect, our paper is related to Branger, Kraft, and Meinerding (2009). They focus on model risk and show that an investor modeling contagion using joint jumps can suffer severe utility losses once he is confronted with a Markov regime-switching framework.…”