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Dynamic Asset Allocation with Event Risk

Jun Liu, Francis Longstaff and Jun Pan

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: An inherent risk facing investors in financial markets is that a major event may trigger a large abrupt change in stock prices and market volatility. This paper studies the implications of jumps in prices and volatility on investment strategies. Using the event-risk framework of Duffie, Pan, and Singleton, we provide an analytical solution to the optimal portfolio problem. We find that event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. In addition, the investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends elements of both dynamic and buy-and-hold portfolio strategies. Jumps in prices and volatility both have an important influence on the optimal strategy.

Keywords: dynamic choice; risk aversion; stochastic volatility (search for similar items in EconPapers)
Date: 2001-08-01
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