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Systemic Portfolio Diversification

Author

Listed:
  • Agostino Capponi

    (Department of Industrial Engineering and Operations Research, Columbia University, New York, New York 10027)

  • Marko Weber

    (Department of Mathematics, National University of Singapore, Singapore 119077, Singapore)

Abstract

We study the portfolio choice problem of banks, taking into account losses due to fire-sale spillovers. We show that the optimal asset allocation can be recovered as the unique Nash equilibrium of a potential game. Our analysis highlights the key tradeoff between individual diversification and systemic risk. In a stylized model economy featuring two banks and two assets, we show that sacrificing individual diversification to reduce portfolio commonality increases the likelihood of a sale event, while simultaneously decreasing the probability of a costly systemic sell-off. Banks have stronger incentives to achieve systemic diversification if there is more heterogeneity in leverage among them, leading to a decrease in the overall vulnerability of the system. We provide numerical evidence that our conclusions are robust with respect to the number of banks and assets in the system.

Suggested Citation

  • Agostino Capponi & Marko Weber, 2024. "Systemic Portfolio Diversification," Operations Research, INFORMS, vol. 72(1), pages 110-131, January.
    • Handle: RePEc:inm:oropre:v:72:y:2024:i:1:p:110-131
    DOI: 10.1287/opre.2022.0290
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