Working Paper: NBER ID: w9103
Authors: Jun Liu; Francis A. Longstaff; Jun Pan
Abstract: Major events often trigger abrupt changes in stock prices and volatility. We study the implications of jumps in prices and volatility on investment strategies. Using the event-risk framework of Duffie, Pan, and Singleton (2000), we provide analytical solutions to the optimal portfolio problem. Event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. The investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends both dynamic and buy-and-hold strategies. Jumps in prices and volatility both have important effects.
Keywords: No keywords provided
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| event risk (G14) | investor behavior (G41) |
| event risk (G14) | portfolio leverage (G32) |
| event risk (G14) | asset allocation (G11) |
| event-related jumps (G14) | investor behavior (G41) |
| event-related jumps (G14) | portfolio choices (G11) |
| jumps in prices and volatility (E32) | portfolio choice (G11) |
| major events (G14) | abrupt changes in stock prices and volatility (G17) |
| abrupt changes in stock prices and volatility (G17) | investment strategies (G11) |
| event risk (G14) | leveraged positions (G19) |
| threat of event-related jumps (C41) | investor behavior as if constrained (G41) |
| volatility jumps (E32) | hold more of the risky asset (G11) |
| anticipated price jumps (E30) | hold less of the risky asset (G11) |