Portfolio diversification, leverage, and financial contagion

Abstract

This paper studies the extent to which basic principles of portfolio diversification explain "contagious selling" of financial assets when there are purely local shocks (e.g., a financial crisis in one country). The paper demonstrates that elementary portfolio theory offers key insights into "contagion." Most important, portfolio diversification and leverage are sufficient to explain why an investor will find it optimal to significantly reduce all risky asset positions when an adverse shock impacts just one asset. This result does not depend on margin calls: it applies to portfolios and institutions that rely on borrowed funds. The paper also shows that Value-at-Risk portfolio management rules do not have significantly different consequences for portfolio rebalancing than a variety of other rules.