Portfolio Diversification, Leverage, and Financial Contagion

38 Pages Posted: 15 Feb 2006

See all articles by Garry J. Schinasi

Garry J. Schinasi

Independent Advisor, Global Financial Stability

R. Todd Smith

University of Alberta

Date Written: October 1999

Abstract

Models of "contagion" rely on market imperfections to explain why adverse shocks in one asset market might be associated with asset sales in many unrelated markets. This paper demonstrates that contagion can be explained with basic portfolio theory without recourse to market imperfections. It also demonstrates that "Value-at-Risk" portfolio management rules do not have significantly different consequences for portfolio rebalancing and contagion than other rules. The paper`s main conclusion is that portfolio diversification and leverage may be sufficient to explain why investors would find it optimal to sell many higher-risk assets when a shock to one asset occurs.

Keywords: financial contagion portfolio choice leverage

JEL Classification: F36 G11 G15

Suggested Citation

Schinasi, Garry J. and Smith, Richard Todd, Portfolio Diversification, Leverage, and Financial Contagion (October 1999). IMF Working Paper, Vol. , pp. 1-38, 1999. Available at SSRN: https://ssrn.com/abstract=880663

Garry J. Schinasi (Contact Author)

Independent Advisor, Global Financial Stability ( email )

Washington, 20008
+1-202-361-0958 (Phone)

Richard Todd Smith

University of Alberta ( email )

8-14 Tory Building
Edmonton, Alberta T6G 2H4
Canada
403-492-7898 (Phone)
403-492-3300 (Fax)

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