Systemic Portfolio Diversification

Agostino Capponi () and Marko Weber ()
Additional contact information
Agostino Capponi: Department of Industrial Engineering and Operations Research, Columbia University, New York, New York 10027
Marko Weber: Department of Mathematics, National University of Singapore, Singapore 119077, Singapore

Operations Research, 2024, vol. 72, issue 1, 110-131

Abstract: We study the portfolio choice problem of banks, taking into account losses due to fire-sale spillovers. We show that the optimal asset allocation can be recovered as the unique Nash equilibrium of a potential game. Our analysis highlights the key tradeoff between individual diversification and systemic risk. In a stylized model economy featuring two banks and two assets, we show that sacrificing individual diversification to reduce portfolio commonality increases the likelihood of a sale event, while simultaneously decreasing the probability of a costly systemic sell-off. Banks have stronger incentives to achieve systemic diversification if there is more heterogeneity in leverage among them, leading to a decrease in the overall vulnerability of the system. We provide numerical evidence that our conclusions are robust with respect to the number of banks and assets in the system.

Keywords: Financial Engineering; systemic diversification; leverage; fire-sale externalities; aggregate vulnerability; network effects (search for similar items in EconPapers)
Date: 2024
References: Add references at CitEc
Citations:

Downloads: (external link)
http://dx.doi.org/10.1287/opre.2022.0290 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:oropre:v:72:y:2024:i:1:p:110-131

Access Statistics for this article

More articles in Operations Research from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().