Working Paper: CEPR ID: DP3305
Authors: Sanjiv Ranjan Das; Raman Uppal
Abstract: Returns on international equities are characterized by jumps; moreover, these jumps tend to occur at the same time across countries leading to systemic risk .In this Paper, we evaluate whether systemic risk reduces substantially the gains from international diversification. First, in order to capture these stylized facts, we develop a model of international equity returns using a multivariate system of jump-diffusion processes where the arrival of jumps is simultaneous across assets. Second, we determine an investor ?s optimal portfolio for this model of returns. Third, we show how one can estimate the model using the method of moments. Finally, we illustrate our portfolio optimization and estimation procedure by analysing portfolio choice across a riskless asset, the US equity index, and five international indexes. Our main finding is that, while systemic risk affects the allocation of wealth between the riskless and risky assets, it has a small effect on the composition of the portfolio of only-risky assets, and reduces marginally the gains to a US investor from international diversification ? for an investor with a relative risk aversion of 3 and a horizon of one year, the certainty-equivalent cost of ignoring systemic risk is of the order $1 for every $1000 of initial investment. These results are robust to whether the international indexes are for developed or emerging countries, to constraints on borrowing and shortselling, and to reasonable deviations in the value of the parameters around their joint estimates; the cost increases with the investment horizon and decreases with risk aversion.
Keywords: Asset allocation; Contagion; Emerging markets; Jump-diffusion processes; Skewness
JEL Codes: F31; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| systemic risk (E44) | allocation of wealth between riskless and risky assets (G11) |
| systemic risk (E44) | portfolio composition of risky assets (G11) |
| investment horizon (G11) | certainty-equivalent cost of ignoring systemic risk (G19) |
| risk aversion (D81) | certainty-equivalent cost of ignoring systemic risk (G19) |
| systemic risk (E44) | portfolio weights (G11) |