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Partial Information about Contagion Risk, Self-Exciting Processes and Portfolio Optimization

Journal of Economic Dynamics and Control, Vol. 39, pp. 18-36

Authors:
Nicole Branger,
Holger Kraft,
Christoph Meinerding
Research Area:
Systemic Risk Lab, Financial Markets, Transparency Lab
Date:
Jan 2014
Keywords:
Asset Allocation, Contagion, Nonlinear Filtering, Hidden State, Self-exciting Processes
Abstract:

This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.

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