Asset Allocation in Markets with Contagion: The Interplay between Volatilities, Jump Intensities, and Correlations
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.
Keywords
Asset allocation; Portfolio choice; Contagion; Systemic risk; Regime switching
Cite as
Konermann, P., Meinerding, C., & Sedova, O. (2013). Asset Allocation in Markets with Contagion: The Interplay between Volatilities, Jump Intensities, and Correlations. Review of Financial Economics, 22(1), 36–46.Details
Publication type
Research article (journal)
Peer reviewed
Yes
Publication status
Published
Year
2013
Journal
Review of Financial Economics
Volume
22
Issue
1
Start page
36
End page
46
Language
English
ISSN
1058-3300
DOI