Dynamic Asset Allocation with Event Risk

Authors

  • Jun Liu,

  • Francis A. Longstaff,

  • Jun Pan

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    • * Liu and Longstaff are with the Anderson School at UCLA and Pan is with the MIT Sloan School of Management. We are particularly grateful for helpful discussions with Tony Bernardo and Pedro Santa-Clara, for the comments of Jerome Detemple, Harrison Hong, Paul Pfleiderer, Raman Uppal, and participants at the 2001 Western Finance Association meetings, and for the many insightful comments and suggestions of the editor Richard Green and the referee. All errors are our responsibility.

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.

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