Market Efficient Portfolios in a Systemic Economy

Abstract

Diversification vs. Diversity – How is the Efficiency of Markets Affected? Prices aggregate information that is dispersed in the economy; they thereby facilitate the allocation of scarce resources. Inefficiencies may arise from deviations of market prices from their fundamental values. In “Market Efficient Portfolios in a Systemic Economy”, Awiszus, Capponi, and Weber investigate the impact of the trade-off between diversity and diversification on inefficiencies in secondary markets due to asset illiquidity and leverage constraints of financial institutions. The authors identify two key determining factors. These are the systemic significance of the banks and the statistical properties of the fundamental asset shocks. Systemic significance is driven by the banks’ target leverage, their trading strategies, and the illiquidity characteristics of the assets. The paper demonstrates that portfolio diversification is typically not efficient. In fact, efficient portfolio holdings may strongly deviate from this standard paradigm, especially if the banks have similar characteristics.