Portfolio Implications of Systemic Crises

Posted: 31 Mar 2006

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

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Abstract

Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton [Merton, R.C., Lifetime Portfolio Selection under Uncertainty: The Continuous Time Case; Review of Economics and Statistics, Vol. 51, pp. 247-257, 1969] style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is 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 the crisis prone emerging markets.

Keywords: Asset allocation, Systemic risk, International finance, Regime switching models

JEL Classification: C51, G11, G15, F30

Suggested Citation

Kole, Erik and Verbeek, Marno and Koedijk, Kees G., Portfolio Implications of Systemic Crises. Journal of Banking and Finance, Vol. 30, No. 8, pp. 2347-2369, August 2006, Available at SSRN: https://ssrn.com/abstract=893500

Erik Kole (Contact Author)

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

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3000 DR Rotterdam
Netherlands
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HOME PAGE: http://people.few.eur.nl/kole

ERIM

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3000 DR Rotterdam
Netherlands

Tinbergen Institute ( email )

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

Marno Verbeek

Erasmus University - Rotterdam School of Management ( email )

P.O. Box 1738
Room T09-53
3000 DR Rotterdam
Netherlands
+31 10 408 2790 (Phone)

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

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Netspar

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

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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