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

Branger Nicole, Kraft Holger, Meinerding Christoph


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.

Keywords
Asset Allocation; Contagion; Nonlinear Filtering; Hidden State; Self-exciting Processes



Publication type
Research article (journal)

Peer reviewed
Yes

Publication status
Published

Year
2014

Journal
Journal of Economic Dynamics and Control

Volume
2014

Start page
18

End page
36

Language
English

ISSN
0165-1889

DOI