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

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

JEL Classification: G01, G11