Extremes and Diversification

Why is understanding extreme events important for individuals? A major reason is that it allows us to protect our property and jobs. The objective of our research is to provide an analysis of the effects of extreme events on household finance and investor diversification. We plan to approach this by analyzing individual behavior, and then asset return behavior. First, regarding individual behavior, we will develop a framework to understand why households and investors may sometimes not diversify their p ortfolios, domestically and internationally, and consequently why they are subject to idiosyncratic risk. After developing this, we analyze empirical evidence, on both international and domestic (Norwegian) investors, to see whether they tend to be undive rsified internationally. Second, regarding asset return behavior, we will develop a parsimonious econometric methodology that can capture comovement across asset returns, in a flexible semi-parametric framework. This framework will allow for realistic time series behavior of the explanatory variables, in particular time variation in the transition probabilities, in order to reflect dynamic information flows. Then we will apply this methodology for international indices from developed and emerging mark et economies, in order to detect, quantify and forecast the effect of limited diversification across international assets. At the end of our research, we will have gained considerable insight into the functioning of financial markets, in particular, a bet ter knowledge of how investment opportunities vary over time. This will enable us to answer our leading questions above, and also provide useful information for analysis of financial contagion.