What is the Impact of Stock Market Contagion on an Investor's Portfolio Choice?

Posted: 17 Mar 2008 Last revised: 6 Sep 2011

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Holger Kraft

Goethe University Frankfurt

Christoph Meinerding

Deutsche Bundesbank

Date Written: August 1, 2009

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.

Keywords: Asset Allocation, Jumps, Contagion, Model Risk

JEL Classification: G11

Suggested Citation

Branger, Nicole and Kraft, Holger and Meinerding, Christoph, What is the Impact of Stock Market Contagion on an Investor's Portfolio Choice? (August 1, 2009). Insurance: Mathematics and Economics, Vol. 45, No. 1, 2009. Available at SSRN: https://ssrn.com/abstract=1101605

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Holger Kraft

Goethe University Frankfurt ( email )

Faculty of Economics and Business Administration
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Christoph Meinerding (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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