Systemic Risk and International Portfolio Choice

59 Pages Posted: 14 May 2002

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: April 2002

Abstract

Returns on international equities are characterized by jumps; moreover, these jumps tend to occur at the same time across countries leading to systemic risk. In this Paper, we evaluate whether systemic risk reduces substantially the gains from international diversification. First, in order to capture these stylized facts, we develop a model of international equity returns using a multivariate system of jump-diffusion processes where the arrival of jumps is simultaneous across assets. Second, we determine an investor's optimal portfolio for this model of returns. Third, we show how one can estimate the model using the method of moments. Finally, we illustrate our portfolio optimization and estimation procedure by analysing portfolio choice across a riskless asset, the US equity index, and five international indexes. Our main finding is that, while systemic risk affects the allocation of wealth between the riskless and risky assets, it has a small effect on the composition of the portfolio of only-risky assets, and reduces marginally the gains to a US investor from international diversification - for an investor with a relative risk aversion of 3 and a horizon of one year, the certainty-equivalent cost of ignoring systemic risk is of the order $1 for every $1000 of initial investment. These results are robust to whether the international indexes are for developed or emerging countries, to constraints on borrowing and shortselling, and to reasonable deviations in the value of the parameters around their joint estimates; the cost increases with the investment horizon and decreases with risk aversion.

Keywords: Asset allocation, contagion, emerging markets, skewness, jump-diffusion processes

JEL Classification: F31, G11, G15

Suggested Citation

Das, Sanjiv Ranjan and Uppal, Raman, Systemic Risk and International Portfolio Choice (April 2002). CEPR Discussion Paper No. 3305. Available at SSRN: https://ssrn.com/abstract=311429

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://algo.scu.edu/~sanjivdas/

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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