Diversification vs. Contagion in Inter-Linked Portfolios

34 Pages Posted: 23 Aug 2011 Last revised: 5 Mar 2013

See all articles by Ramona Meyricke

Ramona Meyricke

UNSW Australia Business School, School of Risk & Actuarial Studies; CEPAR, University of New South Wales; Swiss Re, Australia

Date Written: August 22, 2011

Abstract

Inter-linkages between firms are a channel by which idiosyncratic shocks to one firm can affect the returns of linked counterparties. We extend a factor model of returns to allow for the transmission of idiosyncratic shocks between linked counterparties. We show that the structure of inter-linkages determines the rate at which idiosyncratic shocks are diversified away. Importantly we identify structures in which idiosyncratic shocks do not average out, even in large portfolios, but instead significantly affect returns. Simulations confirm that the structure of inter-linkages affects the rate at which return volatility decays as portfolio size increases. The results provide a theoretical basis for identifying assets, portfolios or markets in which returns are likely to be sensitive to idiosyncratic risk or susceptible to contagion.

Keywords: Aggregate volatility, Contagion, Dependence, Diversification

JEL Classification: D85, E32, G10, G12

Suggested Citation

Meyricke, Ramona, Diversification vs. Contagion in Inter-Linked Portfolios (August 22, 2011). 24th Australasian Finance and Banking Conference 2011 Paper. Available at SSRN: https://ssrn.com/abstract=1915182 or http://dx.doi.org/10.2139/ssrn.1915182

Ramona Meyricke (Contact Author)

UNSW Australia Business School, School of Risk & Actuarial Studies ( email )

Room 2058 South Wing 2nd Floor
Quadrangle building, Kensington Campus
Sydney, NSW 2052
Australia

CEPAR, University of New South Wales ( email )

Level 6, Central Lobby (enter via East Lobby)
Australian School of Business Building
Sydney, New South Wales NSW 2052
Australia

Swiss Re, Australia ( email )

363 George St
Sydney, NSW 2000
Australia

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