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Portfolio Diversification, Leverage, and Financial Contagion

Author

Listed:
  • T. Todd Smith
  • Mr. Garry J. Schinasi

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.

Suggested Citation

  • T. Todd Smith & Mr. Garry J. Schinasi, 1999. "Portfolio Diversification, Leverage, and Financial Contagion," IMF Working Papers 1999/136, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:1999/136
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    Keywords

    WP; management rule; asset position; margin call; financial contagion; portfolio choice; leverage; portfolio management rule; risky assets; portfolio manager; return distribution; leveraged portfolio; conditional asset return distribution; current-period portfolio allocation problem of a portfolio manager; B. portfolio management; Vector autoregression; Personal income; Stocks; Securities markets; Asia and Pacific;
    All these keywords.

    JEL classification:

    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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