Optimal Sovereign Investment in a Stochastic Volatility Jump-Diffusion Model

Abstract

This paper studies optimal sovereign investment and resource allocation decisions in the presence of asset price discontinuities due to stochastic volatility and event related jump risks. We find that: (i) both volatility jumps and positive price jumps increase investment in commodities while negative price jumps reduce such investment. (ii) Optimal portfolio is non-linear in risk aversion while hedging demand tends to dominate the market portfolio. (iii) Volatility jumps have greater impact on optimal portfolio decisions than price jumps and (iv) In the presence of jumps and volatility risks, optimal portfolio is insensitive to asset covariance. Our empirical results indicate that in periods of higher market volatility, government must increase market risk exposure by allocating more resources to commodity investments and reduce such investments when prices are stable and commodity markets are less volatile.