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What is the Impact of Stock Market Contagion on an Investor's Portfolio Choice?

Nicole Branger (), Holger Kraft () and Christoph Meinerding

No 198, Working Paper Series: Finance and Accounting from Department of Finance, Goethe University Frankfurt am Main

Abstract: Stocks are exposed to the risk of sudden downward jumps. Additionally, a crash in one stock (or index) can increase the risk of crashes in other stocks (or indices). Our pape explicitly takes this contagion risk into account and studies its impact on the portfolio decision of a CRRA investor both in complete and in incomplete market settings. We find that the investor significantly adjusts his portfolio when contagion is more likely to occur. Capturing the time dimension of contagion, i.e. the time span between jumps in two stocks or stock indices, is thus of first-order importance when analyzing portfolio decisions. Investors ignoring contagion completely or accounting for contagion while ignoring its time dimension suffer large and economically significant utility losses. These losses are larger in complete than in incomplete markets, and the investor might be better off if he does not trade derivatives. Furthermore, we emphasize that the risk of contagion has a crucial impact on investors' security demands, since it reduces their ability to diversify their portfolios.

JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2009
New Economics Papers: this item is included in nep-rmg and nep-upt
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