Portfolio Implications of Systemic Crises

40 Pages Posted: 7 Aug 2005

See all articles by Erik Kole

Erik Kole

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM; Tinbergen Institute

Marno Verbeek

Erasmus University - Rotterdam School of Management; Erasmus Research Institute of Management (ERIM); Netspar

Kees C. G. Koedijk

Tilburg University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: February 24, 2004

Abstract

Systemic crises can have grave consequences for investors in international equity markets, because it causes the risk-return trade-off to deteriorate severely for a longer period. In this paper we propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton (1969)-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises has a large impact on asset allocation decisions, while the costs of ignoring such crises are substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to emerging markets, being most prone to a crisis. An investor facing short selling constraints withdraws completely from equity markets if the likelihood of a crisis increases.

Keywords: Asset allocation, systemic risk, international finance, emerging markets, regime switching

JEL Classification: G11, G15, F30, C51

Suggested Citation

Kole, Erik and Verbeek, Marno and Koedijk, Kees G., Portfolio Implications of Systemic Crises (February 24, 2004). EFA 2005 Moscow Meetings Paper, Available at SSRN: https://ssrn.com/abstract=533362 or http://dx.doi.org/10.2139/ssrn.533362

Erik Kole (Contact Author)

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute ( email )

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HOME PAGE: http://people.few.eur.nl/kole

ERIM

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Tinbergen Institute ( email )

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HOME PAGE: http://people.few.eur.nl/kole

Marno Verbeek

Erasmus University - Rotterdam School of Management ( email )

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3000 DR Rotterdam
Netherlands
+31 10 408 2790 (Phone)

HOME PAGE: http://www.rsm.nl/mverbeek

Erasmus Research Institute of Management (ERIM)

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3000 DR Rotterdam
Netherlands

Netspar

P.O. Box 90153
Tilburg, 5000 LE
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Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

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