The Effects of Systemic Crises When Investors Can Be Crisis Ignorant

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.

Number of Pages in PDF File: 58

Keywords: asset allocation, systemic risk, international finance, regime switching

JEL Classification: M, M41, G3, G11, G15, F30, C51, G01

working papers series