Abstract
Investors’ portfolios are exposed to different risk factors including diffusion and jump risk. While diffusion risk addresses daily stock market volatility, jumps are used to model event risks like the Lehman debacle. The breakdown of this major US investment bank was perceived as a change in policy by the US administration. This led to a reassessment of jump risk. More precisely, option markets reveal higher risk-neutral jump intensities after the Lehman event. This observation might be explained by either higher empirical jump probabilities or by increasing market prices of jump risk. Both effects have a significant impact on optimal portfolio choice with and without access to the derivatives market. Results indicate that utility improvements from adding derivatives to portfolios increase after the event for both cases. Furthermore, optimal portfolios contain more derivatives that are used for hedging rather than speculation.
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