Portfolio Diversification, Leverage, and Financial Contagion

T. Todd Smith · Garry J. Schinasi

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Financial Risk and Volatility Modeling Global Financial Crisis and Policies Risk and Portfolio Optimization

Abstract

Models of “contagion” rely on market imperfections to explain why adverse shocks in one asset market might be associated with asset sales in many unrelated markets. This paper demonstrates that contagion can be explained with basic portfolio theory without recourse to market imperfections. It also demonstrates that “Value-at-Risk” portfolio management rules do not have significantly different consequences for portfolio rebalancing and contagion than other rules. The paper’s main conclusion is that portfolio diversification and leverage may be sufficient to explain why investors would find it optimal to sell many higher-risk assets when a shock to one asset occurs.

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References

1994The Sharpe Ratio 1990Transmission of Volatility between Stock Markets 1989Transmission of Volatility Between Stock Markets 2000On crises, contagion, and confusion 2000Rational contagion and the globalization of securities markets 1955Safety First and Hedging 1998Contagion 1997Contagion and Volatility with Imperfect Credit Markets

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