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By Mv P, Garry J. Schinasi and R. Todd SmithS Garry, J. Schinasi and R. Todd Smith


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. [JEL F36, G11, G15] The Mexican peso crisis that began in late 1994 was an adverse shock not just to Mexico but to several other countries around the world. Likewise, the financial consequences of the collapse of the Thai baht in 1997 and the unilateral debt restructuring by Russia in 1998 created turbulence in even the largest and most developed capital markets in the world. These episodes have generated interest in why local financial events cause turbulence in financial markets in other countries. In this context, theoretical models have been developed to explain why investors might reduce positions in many risky assets when an adverse shock affects just one asset. These models emphasize how variou

Year: 2011
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