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AbstractWe study the impact of financial contagion on the dynamic asset allocation problem of a CRRA investor facing an incomplete market with two risky assets. We apply a Markov chain regime‐switching framework with state‐dependent jump intensities, diffusion volatilities and diffusion correlations. The key model feature that a switch to the bad contagion regime is triggered by a loss in one of the risky assets allows for the implementation of a hedging demand against contagion risk. Moreover, a state‐dependent diffusion correlation combined with heterogeneity in jump intensities and volatilities can, e.g., generate a flight to quality effect upon a systemic jump.