Asset Allocation in Markets with Contagion: The Interplay between Volatilities, Jump Intensities, and Correlations
Posted: 25 Nov 2011 Last revised: 15 Apr 2013
Date Written: June 28, 2012
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
JEL Classification: G01, G11
Suggested Citation: Suggested Citation