Asset allocation in markets with contagion: The interplay between volatilities, jump intensities, and correlations

In: Review of financial economics: RFE, Volume 22, Issue 1, p. 36-46

Abstract

AbstractWe study the impact of financial contagion on the dynamic asset allocation problem of a CRRA investor facing an incomplete market with two risky assets. We apply a Markov chain regime‐switching framework with state‐dependent jump intensities, diffusion volatilities and diffusion correlations. The key model feature that a switch to the bad contagion regime is triggered by a loss in one of the risky assets allows for the implementation of a hedging demand against contagion risk. Moreover, a state‐dependent diffusion correlation combined with heterogeneity in jump intensities and volatilities can, e.g., generate a flight to quality effect upon a systemic jump.