Portfolio Implications of Systemic Crises
Posted: 31 Mar 2006
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: Suggested Citation