Portfolio choice in markets with contagion

Yacine Aït-Sahalia, Thomas Robert Hurd

Research output: Contribution to journalArticlepeer-review

29 Scopus citations

Abstract

We consider the problem of optimal investment and consumption in a class of multidimensional jump-diffusion models in which asset prices are subject to mutually exciting jump processes. This captures a type of contagion where each downward jump in an asset's price results in increased likelihood of further jumps, both in that asset and in the other assets.We solve in closed-form the dynamic consumption-investment problem of a log-utility investor in such a contagion model, prove its optimality and discuss features of the solution, including flight-toquality. The clustering of jumps gives rise to a time-varying optimal asset allocation: as jumps predict more jumps, the portfolio should be optimally rebalanced to hedge the risk of future jumps. The exponential and power utility investors are also considered: in these cases, the optimal strategy can be characterized as a distortion of the strategy of a corresponding non-contagion investor.

Original languageEnglish (US)
Pages (from-to)1-28
Number of pages28
JournalJournal of Financial Econometrics
Volume14
Issue number1
DOIs
StatePublished - Dec 1 2015

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

Keywords

  • Contagion
  • Flight-to-quality
  • Hawkes process
  • Jumps
  • Merton problem
  • Mutual excitation

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