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Asset allocation with contagion and explicit bankruptcy procedures

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  • Kraft, Holger
  • Steffensen, Mogens

Abstract

In this paper, we consider the asset allocation problem of an investor allocating his funds between several corporate bonds and a money market account. In particular, we provide a realistic model of financial distress: firstly, we model Chapter 7 and Chapter 11 bankruptcies as different possible outcomes of financial distress. Secondly, we take into consideration that, in practice, "default" is not the end, but the beginning of financial distress, eventually leading to a reorganization or a liquidation of a distressed firm. Thirdly and most importantly, we are able to analyze the impact of contagion on an investor's demand for corporate bonds. Contagion is an important phenomenon, as it reduces the investor's ability to diversify his portfolio, and we show that the bond demand can change by more than 50%.

Suggested Citation

  • Kraft, Holger & Steffensen, Mogens, 2009. "Asset allocation with contagion and explicit bankruptcy procedures," Journal of Mathematical Economics, Elsevier, vol. 45(1-2), pages 147-167, January.
    • Handle: RePEc:eee:mateco:v:45:y:2009:i:1-2:p:147-167
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    2. Agostino Capponi & Lijun Bo, 2016. "Robust Optimization of Credit Portfolios," Papers 1603.08169, arXiv.org.
    3. Justin A. Sirignano & Gerry Tsoukalas & Kay Giesecke, 2016. "Large-Scale Loan Portfolio Selection," Operations Research, INFORMS, vol. 64(6), pages 1239-1255, December.
    4. Kraft, Holger & Weiss, Farina, 2023. "Pandemic portfolio choice," European Journal of Operational Research, Elsevier, vol. 305(1), pages 451-462.
    5. Agostino Capponi & Christoph Frei, 2017. "Systemic Influences on Optimal Equity-Credit Investment," Management Science, INFORMS, vol. 63(8), pages 2756-2771, August.
    6. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2009. "What is the impact of stock market contagion on an investor's portfolio choice?," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 94-112, August.
    7. Branger, Nicole & Kraft, Holger & Meinerding, Christoph, 2014. "Partial information about contagion risk, self-exciting processes and portfolio optimization," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 18-36.
    8. Edirisinghe, Chanaka & Gupta, Aparna & Roth, Wendy, 2015. "Risk assessment based on the analysis of the impact of contagion flow," Journal of Banking & Finance, Elsevier, vol. 60(C), pages 209-223.
    9. Lijun Bo & Agostino Capponi, 2017. "Robust Optimization of Credit Portfolios," Mathematics of Operations Research, INFORMS, vol. 42(1), pages 30-56, January.
    10. Patrick Konermann & Christoph Meinerding & Olga Sedova, 2013. "Asset allocation in markets with contagion: The interplay between volatilities, jump intensities, and correlations," Review of Financial Economics, John Wiley & Sons, vol. 22(1), pages 36-46, January.
    11. Chen, Yu & Jin, Shuyue & Wang, Xiasi, 2021. "Solvency contagion risk in the Chinese commercial banks’ network," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 580(C).
    12. Lijun Bo & Huafu Liao & Xiang Yu, 2017. "Risk Sensitive Portfolio Optimization with Default Contagion and Regime-Switching," Papers 1712.05676, arXiv.org, revised Oct 2018.
    13. Giovanni W. Puopolo, 2015. "Portfolio Selection with Transaction Costs and Default Risk," CSEF Working Papers 414, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

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