Dynamic Asset Allocation with Event Risk

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 ofDuffie, 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.