Homework Help: Business: Investing: Domestic Portfolio Choice with Political Event Jump Instability

Political instability causes event-risk jumps in domestic risky asset return. The effects of event-risk jumps on the portfolio decision are inherently linked to their impacts on the conditional moments of the asset return. The arrival of this event is random and the number of event-risk is assumed to be distributed according to a Poisson process.

Although rare events are stochastic and move discontinuously, major events often trigger abrupt change in stock prices even the portfolio choice in equity market. It is found that domestic portfolio choice can benefit from the estimated parameters of the diffusion-jump process more than from the traditional lognormal model. An alternative solution, other than closed-form solution in the past, is also displayed in this letter.

I. INTRODUCTION

The risk of event-related jumps in security prices changes the standard dynamic portfolio choice problem is firstly discussed in Merton (1971). He solves for the optimal portfolio weight with deterministic jump sizes and constant return volatility. Recently, Liu, Longstaff and Pan (2003) use the double-jump framework of Duffie, Pan and Singleton (2000) which is motived by Bates (2000) to investigate the optimal portfolio weight on different jump sizes. In the presence of stochastic environments, the problem of portfolio choice and predictability in stock return has become one of popular topics, for instance, Kim and Omberg (1996), Campbell and Viceira (1999) and Xia (2001).

In the general case, the optimal portfolio weight is given by solving simple pair of nonlinear equations, an analytical result from closed-form solutions for the optimal portfolio weight with a number of special cases are obtain. In this letter, we solve the optimal portfolio weight by jump-diffusion estimation and find an alternative way to solve the decision.

The aim of the present study is to find more efficient portfolio choice by considering the event ”Vjump in risky asset return. The result shows that domestic portfolio choice can benefit from the estimated parameters of the diffusion-jump process more than from the traditional lognormal model.

Homework Help: Business: Investing

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