Portfolio Constraints and Contagion in Emerging Markets

Full Text of this Article (PDF 298K)

Abstract: The objective of this paper is twofold: (1) to analyze an optimal portfolio rebalancing by a fund manager in response to a "volatility shock" in one of the asset markets, under sufficiently realistic assumptions about the fund manager's performance criteria and portfolio restrictions; and (2) to analyze how the composition of the investor base determines the sensitivity of equilibrium asset prices to a shock originating in one of the fundamentally unrelated asset markets. The analysis confirms that certain combinations of portfolio constraints (notably short-sale constraints and benchmark-based performance criteria) can create an additional transmission mechanism for propagating shocks across fundamentally unrelated asset markets. The paper also discusses potential implications of recent and ongoing changes in the investor base for asset price volatility in emerging markets. [JEL G11, G12]